Chapter 2

The circular flow of economic activity

Within the economy, basic economic activities take place. These include production,
consumption, employment, and income generation. They take place through the interrelationship that
is existing between two economic units; and the firm is the basic producing unit.

Let us describe these important economic activities. Production is 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. Whenever resources are used in production, a price is
paid to the resources owners. The and-owner earns rent, the capitalist, interest, and labor his wages.
When the goods and services produced are ready for use, this leads to another economic activity called
consumption.

These activities make up the circular flow of economic activity.

Stock and Flow Variables

To analyze this concept, it is important for us to understand what a flow is. A flow is defined as a
quantity measure over a particular period of time. This term is in contrast to the word stock, which is
defined as a quantity measured as of a given point in time. For example, your money in the bank as of
today is P10,000. Tomorrow, this amount may change; it decreases when you withdraw and increases
when you deposit more funds. Water in a tank is another example of a stock. Now, when you turn on
the faucet and the water starts to get into the tank, there is a flow of water. This flow naturally changes
the stock of water in the tank

The concepts of stock ad flow measurements are essential in understanding the economic
variables of wealth and income. Wealth is anything of value owned. It may consists of money, jewelry,
buildings, and other property. Wealth is a stock since it is what is owned at a particular time. If a fire
destroys the Ayala building in Makati, Ayala’s wealth decreases, now if your mom buys a sweepstakes
ticket and it wins first prize. Your wealth increases by the amount of her winnings.

On the other hand, income is a flow. It is the rate at which we earn money. Our income is very
important to the stock of wealth that we can build up. Income that is saved increases a person’s stock of
wealth. However, expenditures on consumption decreases this stock.

Economic Model of Production

The flow of goods and services moves in a clockwise direction. This we can see in Figure 6.

We see the households delivering economic resources to the business firms for use in
production. It is because these households are the resource owners in the economy. They can own land,
labor, and capital which they provide the firms for use in the production of goods and services. Once
these goods are in their final form, they are now delivered to the households for their consumption.
Before this flow of final goods take place, anther flow in the production process has to take place among
different types of business firms. This consists of the flow of raw materials, the flow of intermediate
goods, and the flow of final goods.

The raw materials are unprocessed goods like logs, wheat, and iron ore. Intermediate goods are
also called goods in process because they have been partially processed but are not yet ready for final
use in consumption. Final goods consist of the bread we buy in the bakeries, a car, the table and chairs
we use.

Some firms are raw materials producing firms. They cut down lumber from the forests or
explore mines for ores. Some firms transform these raw materials into intermediate goods. An
automobile body shop does this to iron sheets. And of course we have firms that convert these
intermediate goods into final goods, such as when a firm finishes up the car so it is ready for us to ride
in.

Let us now show the existing interrelationship among these three types of firms.
 Figure 7 shows the relationships among the different firms. It is incomplete because it does not
show the rule of the household in production as resource owners. Let us now add this in the figure.

Integrating these two figures above, we now have the complete picture.
ECONOMIC MODEL OF INCOME AND CONSUMPTION

The flow of physical goods is normally accompanied by a flow of income. In figure 9, we can see
that in return for resources delivered by the households to the firms, they get a money payment which
becomes income to them. The circular flow of income is in a counterclockwise direction. We shall
illustrate this in figure 10.

The flows of income and consumption expenditures are flows which involves financial
transactions since they involve the payment of money. When economic resources are delivered by the
households to the business firms, income in generated in the form of wages, rents, and interest earned.
This income is now the source of funds of households, needed for them to buy goods and services in
consumption. Thus, money payment is given by the household for the purchase of goods and services.

A money flow is also involved in the interfirm transactions in production. We will now show this
financial flow.
 Combining the circular flow of physical transactions and the circular flow of financial
transactions, we arrive at figure 11.

The final output of goods within the flow consists of:

First: goods used in consumption, called consumer goods;

Secondly: goods used in the production of other goods, called capital, producers or investment
goods.

The value of this final output of goods is equal to the value of the expenditures on these goods.

THE CIRCULAR FLOW OF OUTPUT AND INCOME

The two flows of output and income are exactly equal. Thus, the value of all goods and services
produced in the economy during a year is equal to the money which business firms spent, and which
households as resource owners received. Within the circular flow, the measure of output and the
measure of income always result in the same value. This is because for every peso value of output
produced one peso of income is created.

In figure 12, what we see is a simplified model, showing only the household and the firm. Let us
see what happens in the flow when we add two other important elements: the government and the
foreign countries.

The government makes two types of purchases in the economy. It hires labor from the
household sector, rents their land for their offices and factories, borrows capital by selling securities. For
these it makes money payments to the households. The government also buys goods from business
firms, and makes money payments for these purchased.
Figure 13. The Circular Flow of Goods and Income of Households and Firms with the Government and
Foreign Countries

The Circular Flow of Goods and income of Households and Firms with the Government and Foreign
Countries

An open economy like the Philippines maintains trade relations with other countries. First, it
sells goods to these countries, in the form of exports. The Philippines’ main export products are mostly
agricultural, like coconut, sugar, and banana. For these, foreign countries make payments to the
business firms which sell to them. In turn, the Philippines also buys from other countries goods and
services called imports. Among the important imports of our country are oil, machinery, and
manufactured goods. For these imports, Philippine households have to make payments to foreign
countries from which they buy.

The circular flow of economic activity implies:

1. The goods, resources, and money payments will flow as long as households continue to
consume, and as long as firms continue to produce; and
2. That since goods and resources flow I 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 AND THE CIRCULAR FLOW

An amount of spending that goes into the economic stream generates a corresponding amount
of income which is greater than the original inflow. This is due to the multiplier effect. The multiplier is a
number that determines the increase in income resulting from a given amount of income but in a higher
amount. The multiplier, in effect increases the resulting income depending on the consumption behavior
of the people. An income multiplier of 10 will generate an income of P10 on a P1 inflow.

A more detailed analysis of the multiplier effect is presented in a future chapter, where income
generated by he multiplier is related to the people’s propensity to consume.

INFLOWS AND OUTFLOWS

Consumption is the mainstream of the circular flow. If within the year, the business firms
produced a total of P50 billion worth of goods and services, it would follow that the income of
households would total P50 billion and their spending would be P50 billion if the total demand for goods
produced in a year equals the amount of output, business would be able to sell all that they produce.
However, households do not usually spend all of their income. While most of a person’s income is spent
for consumption, it is usual that a portion of this income is saved. If there were no other demand aside
from that of the households, the business firms would definitely not be able to sell all of their output.
Thus, savings have the effect of decreasing the level of economic activity in the flow. Savings constitute
the first outflow form the stream.
 The existence of the government in the model necessitates the study of tax payments that
households have to pay the government on their income. When households pay taxes, the effect is to
lessen their disposable income and therefore the amount available for consumption spending. Look at
Table 3 that shows how taxes affect the consumption schedule of households.

A comparison of the three schedules shows the effects of taxes on consumption spending and
savings. With the introduction of taxes in the economy, as seen in schedule 2, in the table, the amounts
going to consumption decrease relative to the amounts shown in Schedule 1. When taxes are increased
to P150, the amounts for consumption spending further decrease. Taxes therefore decrease the level of
economic activity in the flow and constitute our second outflow.

When we bring in the rest of the world and buy from foreign countries, this amount is spending
on the part of households, but these expenditures are not siphoned back to our economy in the form of
payments to local business firms. Instead, these payments flow into foreign countries from whom we
purchase our imports. Imports therefore have the effect of decreasing the level of economic activity and
constitute our third outflow.

With these outflows taking place in the economy, we are bound to experience a continuous
recession of economic activity. However, this could be offset by a siphoning of funds back into the
economic flow.

Firstly, when households save, the normal practice is to bring this money to banks as deposits.
These banks will now use these funds by investing them, thereby making payments to the business
sector; or by lending them to people who likewise invest the money. Herein lies our first inflow which id
investment. If investment is equal to savings, it offsets the outflow caused by the savings of households.

When the government collects the payment made by households in the form of taxes, the
government uses these collections to defray expenses such as infrastructure, social services, education,
economic development, etc. these amounts are spent back into the flow and offset the outflow of taxes.
Government spending is, thus, our second inflow.

When the Philippines purchases goods from other countries, it is because it expects these
countries to reciprocate by buying its locally produced goods. When the Philippines exports goods to
other countries, they pay us and this money goes into the flow. Exports are the inflows that offset the
outflows of imports.

When the outflows in the economy equal the inflows, the level of economic activity is
maintained. However, an excess of inflows over outflows will be expansionary since it will increase the
level of economic activity. The opposite effect will hold when outflows exceed inflows. The result is a
contracting effect since it results in a decrease in the level of economic activity.

After making a study of the inflows and outflows, we can now present a complete picture of the
circular flow of economic activity.

A desire to change the level of economic activity in the flow may lead to the manipulation of a
country’s inflows and outflows. Outflows are, however, difficult to control because they are dependent
on income. When income increases, we expect savings, taxies and imports to increase.
 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 may be adopted. That of which affects savings and investment is
called monetary policy. That which controls taxes and government expenditures is fiscal policy. And that
which affects a country’s exports and imports is its trade policy. The government applies the policies in
accordance with its goal. A policy may be “easy” when the government’s aim is expansion. A policy
tends to be “tight” when there is a need to restrict the circular flow by making less funds available in the
economy.
Exercise 1. Indicate the effect of the following on the Circular Flow of Economic Activity (Increase,
Decrease, No Change)

_______________ 1. Savings
_______________ 2. Taxes
_______________ 3. Consumption spending
_______________ 4. Exports
________________ 5. Imports
________________ 6. Government surplus budget
________________ 7. Government deficit budget
________________ 8. Government balanced budget
________________ 9. Favorable balance of trade
________________ 10. Unfavorable balance of trade
________________ 11. Investments
________________ 12. Balance of trade
________________ 13. Tourist spending
________________ 14. Disinvestments
________________ 15. Equal inflows and outflows

Exercise 2. Classify the following as:

Consumption (C), Investment (I), Government spending (GS)
______________ 1. Infrastructure expenditure
______________ 2. Payroll of San Miguel Corporation
______________ 3. Electrical consumption of a corporation
______________ 4. Stock of jeans of Levi’s
______________ 5. Your purchases of jeans
______________ 6. Meralco’s oil consumption
______________ 7. Clothing merchandise of a corporation
______________ 8. Your clothing expenditure
______________ 9. Maintenance of Rizal Park
______________ 10. Salaries of congressmen
______________ 11. Your family’s car purchase
______________ 12. Your family’s gasoline consumption
______________ 13. Construction expenditure on your new home
______________ 14. Stock of appliances of ShoeMart
______________ 15. Computers in a law firm.
______________ 16. Electrical consumption of NVSU
______________ 17. Salaries of public school teachers
______________ 18. Salaries of school personnel
______________ 19. Clothing expenditure of your professor
______________ 20. Milk expenditure of your baby sister