Economic activity: The circular flow of income model

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In a closed economy with no government the households buy the nation’s output of goods and services and are owners of all the economy’s factors of production. They supply these factors of production to the firms and receive payment from them. By hiring these factors of production from the households, the firms make all of the nation’s output of goods and services.

A country’s income is usually measured using GDP, however there are three main different methods for calculating GDP: output, income and expenditure.

Output method: measures the actual value of all goods and services produced in the country.

Income method: measures the value of all incomes earned in the economy.

Expenditure method: measures the value of all spending on goods and services. This includes household spending (consumption), spending by firms (investment), government spending, and spending on exports minus spending on imports.

This shows the circular flow of income in an open economy with government and financial markets.

The size of the circular flow depends on the size of the injections (STM) and leakages(GIX).

When injections rise relative to withdrawals the economy will expand and when withdrawals rise relative to injections the economy will contract.

Business cycle

A. Depression/ Trough:

Consumer confidence: ↓

Business confidence:  ↓

Consumption: ↓

Investment: ↓

House prices/Share prices: ↓

Unemployment: ↑

Inflation: ↓

Balance of Payments: ↑ (less M)

Household debt: ↑

Government budget: ↓ (deficit)

B. Recovery:

Consumer confidence: ↑

Business confidence:  ↑

Consumption: ↑

Investment: ↑

House prices/Share prices: ↑

Unemployment: ↓

Inflation: ↑

Balance of Payments: ↓ (more X)

Household debt: ↓

Government budget: ↑

C. Boom/Peak:

Consumer confidence: ↑

Business confidence:  ↑

Consumption: ↑

Investment: ↑

House prices/Share prices: ↑

Unemployment: ↓

Inflation: ↑

Balance of Payments: ↓ (more X)

Household debt: ↓

Government budget: ↑ (surplus)

D. Depression:

Consumer confidence: ↓

Business confidence:  ↓

Consumption: ↓

Investment: ↓

House prices/Share prices: ↓

Unemployment: ↑

Inflation: ↓

Balance of Payments: ↑ (less M)

Household debt: ↑

Government budget

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