The Circular Flow of

Economic Activities

BS Economics 1-2
Warm-up Question

•What are the things you

do with your
money/income?
ECONOMY
What is economy?
Differentiate
Economy to
Economics
Four Basic Economic Activities
•Production

-the use of economic resources in the

creation of goods and services for the
satisfaction of human wants

-the use of these economic resources in

production is EMPLOYMENT
Four Basic Economic Activities
•Consumption
-the act of using up the goods and services
to satisfy human wants by consumer
purchasing or in the production of other
goods
-the mainstream of circular flow
Four Basic Economic Activities
•Employment

-the use of economic resources in

production; engagement in activity
Four Basic Economic Activities
•Income Generation
The production of maximum amount an
individual can spend during a period
without being any worse off and being able
to generate/create income.
Four Basic Economic Activities
•Production
•Consumption
•Employment
•Income Generation
Two Basic Economic Units
•Household
-the basic consuming unit
-resource owners (land, labor,
entrepreneurship, and capital)
-deliver the economic resources to the
business firms for use in production
Two Basic Economic Units
•Firm/Business
-the basic producing unit
-resource developers
-produces goods and services out of the
factors of the production given by the
household
Stock and Flow Variables
•Flow
-a quantity measured over a particular
period of time, recurring
-can be calculated on/expressed per
unit of time, e.g., hourly, weekly,
monthly or yearly basis but should be
measurable only over a period of time
Stock and Flow Variables
•Stock
-the quantity measured as of a given point
in time, non-recurring
-measured at one specific time, and
represents a quantity existing at that point
in time which may have accumulated in the
past
Wealth and Income as Economic Variables
•Income
-the rate at which we earn money
-it is a flow since income that is saved, increases
the stock of wealth
•Wealth
-anything of value owned
-it is a stock since it is what it is owned at a
particular time
Circular Flow Models
 Economic Model of Production
The Circular Flow of the Production Process
Economic Resources

PRODUCING
HOUSEHOLDS UNITS
(FIRMS)

Goods and Services

The flow of goods and services moves in a clockwise direction

 Economic Model of Production
The Circular Flow of Goods Among Production Units
Raw Materials
Intermediate Good
Firm
Raw Material
Firm

Consumers Intermediate
Goods

Final Goods Final Good

Firm

The flow strictly shows the relationships among the different firms. It is incomplete
because it does not show the role of the household in production as resource owners.
 Economic Model of Production
The Circular Flow of Goods Among Production Units

•Raw Material Firms

-firms that produce raw materials such as fish,
sugarcane, and other
•Intermediate Goods Firms
-firms that produce goods that are partially
processed and still need further processing before
they can finally be consumed
Ex. Flour, steel bars
 Economic Model of Production
The Circular Flow of Goods Among Production Units

•Final Good Firms

-firms that produce goods that are redy for final
consumption
Such as candies, RTW clothing, etc.
 Economic Model of Production
Interrelation Between Production Units and Households

Resources Raw Material Firm

Households Resources
Intermediate Good Firm

Resources Final Good Firm

 Economic Model of Production
The Circular Flow of Goods and Income Among Producers and Households

Resources
Raw Material
Money Payment for Resources Firm

Resources
Intermediate
Money Payment for Resources Good Firm
Households
Resources

Money Payment for Resources

Final Good
Money Payment for Purchase of Final Goods Firm
Final Goods
 Economic Model of Production
The Circular Flow of Goods and Income Among Producers and Households

The flow strictly of physical goods is normally

accompanied by a flow of income, through this figure we
can see that in return for resources delivered by
households to the firms, they get money payment as
factor income.
Economic Model of Income and Consumption
The Circular Flow of Income

Income Flow of Wages, Interests, Rents

Producing
Households Units
Purchases of Goods and Services

The circular flow of income is in a counterclockwise direction.

The flows of income and consumption expenditures are flows
which involve financial transactions since they involve the
payment of money.
Economic Model of Income and Consumption
The Circular Flow of Income Among Production Units

Money Payments For Raw Materials

Raw Intermediate
Materials Good Firm
Firm
Money Payments For Intermediate Goods

Final Good
Firm Money Payments For Final Goods

Households
This circular flow is the combination of the circular
flow of physical transactions and the circular flow of
financial transactions.
Economic Model of the Circular Flow of Output
and Income
The Circular Flow of Physical Goods and Money Income

Economic Resources

Money Payments of Rents, Waged, Interests

Households Business
Sector

Goods and Services

Money Payments for Purchase of Goods and Services
 The Circular Flow of Goods and Income of Households
and Firms with the Government and Foreign Countries

Wages, Transfer Payments Purchase of Goods and Services

Taxes Government Taxes

Economic Resources

Purchase of Goods and Services

Households Business
Income Payments, Wages, Rent, Dividends, and Interests Sector

Goods and Services

Foreign
Money Payments for Imports
Countries Money Payments for Exports
Implications of the Circular Flow of Economics Activity

• The goods, resources, and money payments will flow

as long as households continue to consume, and as
long as firms continue to produce.
• That since goods and resources flow in exchange for
payments, the rate of payments flow will in the end
be the same.
• Money is the inducing factor, and the pillar of the
price system. Without it, there is no price system.
The Multiplier Effect
•Comes about because
injections of new demand for
goods and services into the
circular flow of income
stimulate further rounds of
spending
The Multiplier Effect
•Gives numerical answers
about the effect of changes in
aggregate expenditures on
aggregate output.
The Multiplier Effect
•One person’s spending is
another’s income
•This can lead to a bigger
eventual effect on output and
employment
The Multiplier Effect
The Circular Flow of Economic Activity Reflecting the Outflows and Inflows

Economic Resources

Purchase of Goods and Services

Producing
Households Units
Income Payments, Wages, Rent, Dividends, and Interests

Goods and Services

IMPORTS Foreign Countries EXPORTS

TAXES Government EXPENDITURES

SAVINGS Banks INVESTMENTS

Inflows and Outflows
•Outflows
-are factors that decrease the
level of economic activity
- savings, taxes, and imports
Inflows and Outflows
•Outflows
-are difficult to control because
they are dependent on income.
-when income increases, we
expect savings, taxes, and
imports to increase
Inflows and Outflows

•Inflows
-factors that increase the level of
economic activity
-investment, government
spending, exports
Inflows and Outflows
•Inflows
-are easier to manipulate
-the proper use of policy enables the
government to encourage exports and
investments and to increase its
expenditures when it desires to expand
the flow of economic activity
Three Sets of Policy
•Monetary Policy
-affects the savings and investment
•Fiscal Policy
-controls taxes and government
expenditures
•Trade Policy
-affects a country’s exports and imports