The circular flow of money model for students of BA1 
                  This article is about the determination of macroeconomic 
                  phenomena, equilibrium, national income, growth in national 
                  income price inflation and unemployment. This article will focus on 
                  national income, equilibrium and the circular flow of money model. 
                  National income, output, and expenditure are generated by the activities of the two most vital 
                  building blocks   of an economy, households and firms, as they engage in mutually beneficial 
                  exchange. 
                  In a simple economy where there are only firms (producers) and households (consumers), 
                  the primary economic function of households is to supply firms with required factors of 
                  production - land, labour, capital and enterprise. These are supplied in return for a reward 
                  (land receives rent, labour receives a wage, capital receives interest, and enterprise 
                  receives a profit). 
                  Therefore in a simple economy: 
                          Households pay for goods and services they consume with the income they receive 
                           from selling their factors; and 
                          Firms supply goods and services to households – utilising the four factors of 
                           production. 
                  In this situation the circular flow of is neither increasing nor decreasing, and equilibrium is 
                  where income (Y) equals consumption (C). 
                  In the macro economy, the circular flow fluctuates as injections (J) or withdrawals (W) occur. 
                  An injection will increase the flow, and a withdrawal will do the opposite. 
        
       Injections 
       Injections are recognised as additional expenditure that are from outside the circular flow. 
       For example, firms may purchase (invest in [I]) capital goods, such as machinery, from other 
       firms, and this spending is an injection into the circular flow. Government investment (G) in 
       public and merit goods like defence and policing, education, and healthcare boosts the 
       circular flow. And finally, foreign households and firms buy domestic products, called exports 
       (X), and this brings money from overseas into the circular flow. 
       Withdrawals 
       Withdrawals reduce the circular flow. Households may choose to save (S) some of their 
       income (Y) rather than spend it (C). In addition to saving (S), households pay taxes (T) to 
       the government, removing money from the circular flow. Finally, households spend some of 
       their income (Y) on imports (M) – goods from abroad, so money flows overseas; and out of 
       the circular flow. 
       Equilibrium 
       For equilibrium in a macro economy to occur, planned injections need to be equal to planned 
       withdrawals: 
       Equilibrium is where: 
                    Injections (J) = Withdrawals (W) 
       This is also sometimes written as 
                   Equilibrium (E) = C + I + G + (X – M) 
       National Income 
       If injections (J) are greater than withdrawals (W), then more money is coming into the 
       circular flow than is leaving it and national income will rise. The opposite happens when 
       withdrawals and greater than injections; national income falls. 
         
        
        
       Greece - the circular flow of money and equilibrium 
       Greece became the epicenter of Europe’s debt crisis after the Wall Street crash in 2008. 
       With global financial markets still reeling, Greece announced in October 2009 that it had 
       been understating its deficit figures for years, raising alarms about the soundness of Greek 
       finances. 
       Suddenly, Greece was shut out from borrowing in the financial markets. By the spring of 
       2010, it was veering toward bankruptcy, which threatened to set off a new financial crisis. 
       To avert calamity, the so-called troika — the International Monetary Fund, the European 
       Central Bank and the European Commission — issued a number of international bailouts. 
       The bailouts came with conditions. Lenders imposed harsh austerity terms, requiring deep 
       budget cuts (reduction in G) and steep tax rises (increase in T). 
       The money was supposed to buy Greece time to stabilize its finances and quell market fears 
       that the euro union itself could break up. However, the bailout money mainly goes toward 
       paying off Greece’s international loans, rather than making its way into the economy. And 
       the government still has a staggering debt load that it cannot begin to pay down unless a 
       recovery takes hold. 
       Many economists, and many Greeks, blame the austerity measures for much of the 
       country’s continuing problems. 
       If we think back to the simple circular flow of money model, and injections (J) and 
       withdrawals (W), by reducing government investment (G) and increasing taxes (T) we have 
       created a situation where national income falls as J < W (injections are smaller than 
       withdrawals). If national income falls, households are less likely to consume (C), firms are 
       reluctant to invest (I), which may that they have to reduce the amount they spend in income 
       (Y) which potentially causes a recession. 
       While the bailout has helped, Greece’s economic problems haven’t gone away. The 
       economy has shrunk by a quarter in five years, and unemployment is above 25 percent. 
        
       Questions 
       1  In the circular flow model of the economy, the level of national income will always 
          reach equilibrium because: 
          A.  Injections and withdrawals are always equal. 
          B.  Withdrawals are a function of the level of income. 
          C.  Governments will change taxes and expenditure to ensure equilibrium. 
          D.  Expenditure equals income. 
        
       2  Which of the following is least likely to result in a fall in household consumption? 
          A.  An increase in interest rates 
          B.  A reduction in the availability of credit 
          C.  An increase in the rate of inflation 
         
                 
                        D.  An increase in the rate of income tax 
                 
                3       All of the following government policies would tend to raise national income over time 
                        EXCEPT which ONE? 
                        A.  Increased expenditure on the economic infrastructure. 
                        B.  Tax cuts to encourage higher demand from consumers. 
                        C.  Policies to encourage the training of labour. 
                        D.  Financial incentives to encourage personal and corporate saving. 
                 
                Answers 
                1       B.     Withdrawals are a function of the level of income. 
                2       C.     An increase in the rate of inflation 
                               People tend to buy goods now if they think the price is going to increase in 
                               the long run 
                3       D.     Financial incentives to encourage personal and corporate saving.