CIRCULAR FLOW
The basic circular flow diagram
There are millions of people who engage in an economy on a daily basis. If you
think about yourself – you go to the shop and buy a loaf of bread. By doing this, you
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are engaging in the economy. Someone had made the bread, sold the bread and
you bought the bread. Many people were affected by that simple transaction. In
economics, there is a model that explains the relationship between the different
parties and this is known as the circular flow model. We are going to start simply
where we assume there is only a producer and a consumer and we will draw a
diagram to see the relationship between those two parties.
CIRCULAR FLOW The basic circular flow diagram
The basic circular flow diagram
Look carefully at the previous diagram and see which way the arrows are going:
From the Household to the Producers: it is indicating that the households supply
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the factors of production (natural resources; labour; capital; entrepreneurship).
The Households are also using the money they earn from these factors of
production to buy goods and services from the Producers.
From the Supplier to the Households: The Producer is supplying goods and
services to the Households. The Producers are paying the Households for the
factors of production.
NOTE: The inside flow (black line) is the flow of goods and services and must
always be on the inside. The outside flow (orange line) is the flow of money and
must always be on the outside.
CIRCULAR FLOW Expanding the basic circular flow diagram
Expanding the basic circular flow diagram
This is the same diagram as the first one except that the factor market and the
product market have been included. The factor market is where the factors of
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production are ‘sold’. Households would earn an income here and use this income
to buy goods and services from the product market.
Factor market
Product market
CIRCULAR FLOW Circular flow diagram with government
The government is also part of the circular flow diagram in that businesses (suppliers)
and households must pay tax to the government. They, in return, receive goods and
services from the government. Households receive infrastructure such as roads, traffic
lights and water to name a few.
CIRCULAR FLOW Circular flow diagram with the foreign sector
Circular flow diagram with the foreign sector
The foreign market is the international market. South African households can buy
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goods from other countries e.g. Germany (imports) and therefore, goods would
flow into the households from Germany and money would flow from South Africa
to Germany to pay for these goods. Likewise, goods from South Africa can be sold
to other countries (exports) e.g. India and in this case, goods go from the product
market to India and the money flows into South Africa to pay for these goods.
PARTICIPANTS IN THE
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The four main participants
In the circular flow, there are four main participants
CONSUMERS
PARTICIPANTS
PRODUCERS
GOVERNMENT
FOREIGN SECTOR
Consumer
Consumers are households (you and me), the government is also a consumer as well
as businesses as they all buy goods and services. Suppliers will base their production
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on what consumers are demanding. For example, if nobody demands spinach juice,
the supplier will not make it as they would not be able to sell it. If consumers are
demanding beetroot juice though, it would be in the interest of suppliers to make it
and supply it. Businesses who are making the beetroot juice would be consumers in
that they would be buying beetroot, bottles and caps from suppliers. The government
are consumers – for public hospitals they would need to buy beds, bedding, medical
supplies etc and in this way, they become consumers.
Producers
Producers are businesses who produce and supply the goods. They can be privately
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owned, or state owned. They can also be formal businesses or informal businesses.
Producers look at what consumers want and produce to satisfy their needs.
Government
The government is a producer and a consumer. They are a producer in that they must
supply goods and services to citizens such as health, education, welfare, security. They
are also consumers in that they must purchase goods and services for the services
that they offer such as roads, traffic lights, health, education.
Foreign sector
This is part of international trade and if a country has an open economy, it means that
they trade with the rest of the world.
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If a country does not trade with other countries, it would have a closed economy.
Imports is when a country buys goods from another country. For example, if South
Africa buys goods from Spain, South Africa is importing goods from Spain. South
Africa would need to pay for these goods and therefore money is flowing out of South
Africa into Spain.
Exports is when a country sells goods to another country. For example, if South Africa
sells goods to Germany, South Africa is exporting goods to Germany. Germany would
need to pay for these goods and therefore money is flowing into South Africa.
Real flow and money flow
A market is a place where buyers and sellers meet. It does not have to be a physical
space but can also be an online space e.g. Takealot. When looking at the circular flow
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diagram, there are two markets we will initially be looking at:
1. The factor market which is the ‘market’ where the factors of production are bought
/ sold. For example, the market where labour is sought / the market for capital goods /
the market for entrepreneurs / the market for natural resources.
2. The goods or product market which is where goods and services are sold. If you
look at the shops around you, you will see that there are many – cafes, restaurants,
clothing stores, music stores and then there is all the online shopping.
PARTICIPANTS The real flow
The real flow in an economy is the flow of goods and services from the product market to
the households or the flow of factors of production from the households to the producers.
Remember: Consumers own the factors of production which they 'sell’ to the Producers.
Producers own the goods / services which they ‘sell’ to the Consumers. The inside lines of
the circular flow model represents the real flow in an economy.
The money flow
The money flow is Income is earned from the factors of production which are owned by the
households. This income is then used (spent) to buy goods and services. The spending
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becomes an income to the business who uses the income to pay for the factors of
production.
The flow of money can be seen on the outside of the circular flow diagram. When
consumers spend money on goods and services, it becomes an income to the suppliers.
When suppliers use the factors of production that are owned by the consumers, it becomes
an income to the households.
Leakages from the circular flow
This is money that leaks out from the circular flow. If people save money, they are not
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spending it on goods and services and are therefore taking it out of the circular flow
until such time as they use their savings to buy goods / services.
When people pay tax either on their income or on goods and services (VAT), they are
not spending that tax money on goods and services. Tax is therefore removed from
the circular flow. If, for example, you earn R10 000 and pay R2 000 income tax, you
have R8 000 to spend (disposable income). Ignoring VAT and savings, only R8 000
goes into the circular flow to buy goods and services.
Leakages from the circular flow
When buying goods from other countries (importing), you are taking your money and
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spending it in another country and therefore taking it out of the circular flow of this
country. If you have R8 000 and spend R1 000 on imports, you are only spending
R7 000 on South African goods and services.
Injections into the circular flow
When people pay tax, the tax is used by the government to buy goods and services.
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This money was leaked out of the circular flow when tax was paid, but is now injected
back into the circular flow when the government uses that money to buy goods and
services such as hospital beds, materials for schools etc.
Businesses purchase capital goods such as machinery, vehicles, or raw materials.
These goods are used to make goods for the purpose of running a business and these
goods are called capital goods and are an investment. This causes an injection into an
economy as it is an addition to the flow of money.
Injections into the circular flow
When selling goods to another country (exporting), you are bringing money into the
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country. If you sell South African goods for R5 000 to someone in Italy, they are
sending money from Italy to South Africa. This is therefore an injection into the
circular flow.
Equilibrium in an economy
An economy is in equilibrium when the leakages = injections (L = J)
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which is: S + T + M = G + I + X
The following diagram shows how imports (orange line) and exports (green line) are
shown as an injection and leakage on the circular flow. Households are spending
money in the foreign market (leakage) and the foreign market is spending money on
goods and services from South Africa (injection).
Leakages and injections from X and M
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GDP and GNI
PARTICIPANTS National accounting aggregates
GDP is measured how much output is being produced within the borders of a country
irrespective of who owns the factors of production. When measuring GDP in South
Africa, it will be reported in Rands. When measuring the GDP in UK it will be reported
in Pounds. However, when comparing the GDPs of various countries, it will all be
brought down to a common currency which will be the US Dollar.
Gross National Income is the value of goods produced by the citizens of a country
irrespective of whether they are in the country or not.
Calculating GDP
When calculating GDP, the final value must be used. For example, if a wooden table is
being produced and sold:
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Cost of wood for the table R500
Cost to manufacture the table R1 000
Sale of table to the shop R1 800
GDP is therefore R1 800.
You cannot include the other components in the calculation i.e. the cost of the wood
and the cost to manufacture the table as this has been included in the selling price of
the table. If you did include it, there would be double counting taking place.
Calculating GNI
The gross national income is the total value of all finished goods produced by the
citizens of that country even if the factor or the raw materials are in another country.
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When doing the circular flow, we assume that all income earned from the households
(who own the factors of production) are spent in the goods and services market. With
this assumption, income = expenditure.
Calculating GDP : Expenditure method
GDP (E) = C + I G + + (X – M)
C = Consumer spending
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I = Investment spending by firms
G = Government spending
X = Exports
M = Imports
*X – M because Imports were not produced within the borders of the country.
Calculating GDP : Income method
GDP(Y) = w + R + I + P
w = Wages
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R = Rent
i = Interest
P = Profit
In other words, it is the payment received from the factors of production.
NOTE: The upper and lower case must be correct for your formula to be correct.
Calculating GNI
GNI = GDP + factor income earned by South Africans living in another country – factor
income earned in South Africa by foreigners.
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The importance of GDP and GNI
GDP measures how well a country’s economy is doing whereas GNI measures how
well the citizens of a country are doing.
They also serve to compare one year to the next by seeing if there has been an
increase of decrease in the GDP / GNI figures. GDPs can also be compared with other
countries.