The Circular Flow Model

Question 1: `the circular flow model shows how real resources and financial payments are exchanged between firms and households.`(begg, fischer & dornbusch)
a) explain this statement
b) draw the circular flow model of an economy
c) define leakages (withdrawals) from the circular flow
d) define injections into the circular flow
e) explain how equilibrium is achieved in the circular flow

Question 2: using appropriate IS/LM diagrams show:
a) how equilibrium income and the interest rate are determined in a closed economy
b) how an increase in government spending can affect equilibrium income and interest rate
c) what is meant by `crowding out`

Circular Flow Model
“The circular flow model shows how real resources and financial payments are exchanged between firms and households.(Begg, Fischer & Dornbusch)” The statement is based on a economic model promulgated by Adam Smith that provides for the circular flow of goods and services and money between two sectors: firms and households. Households provide labor and land for firms, who in turn produce goods and services for the households. Households receive rent and wages for the labor, land (known as factors of production), which use the money received to purchase goods and services from the firms.

Leakages in the circular model occur when other sectors, i.e. government, overseas, and the finance sectors, extract money from firms and households, while injections occur when these other sectors infuse money to firms and households. Leakages happen when not all money and goods and services are paid to the firms and households, i.e. (i) when household deposit money in banks, (ii) households and firms pay taxes to the government, and (iii) household export, pay for goods produced by firms outside the economy. Injections occur when money, other than from firms and households, are infused to the economy. This occurs when (i) government spend money to provide basic services, roads, buildings, etc., to households and firms, (ii) banks invest money in firms by buying stock or bonds, and (iii) overseas households, in a foreign trade, buy goods pay for goods produced by firms inside the model.

Equilibrium occurs when supply is equal to demand in the markets for (i) labor and capital, and (i) goods and services. When this occurs, we generally have a stable economy, when leakages equal to injections – investments and government spending equal savings and taxes. Equilibrium is not achieved in a contracting economy, which happens when taxes to government plus savings are higher leakages are higher than investments and government spending. This results to less spending by households, thus inventory accumulation by firms. In an expanding economy, injections (investments and government spending) are higher than savings and taxes. Hence, more money enters the economy, resulting to more goods and services and higher prices due to increasing demand.

IS/LM Diagram

The LM Curve is an upward sloping curve in diagram comparing income (on the horizontal axis), and interest rates (on the vertical), representing that an increase in income or GDP implies in increase demand for money, hence higher interest rates. The IS curve is a downward sloping curve showing investment as a function of interest rate. The IS curve is sloping downwards because, (i) higher level of savings requires higher income or GDP, and (ii) GDP is increased by higher investments. The point of intersection of the IS and LM curve implies an equilibrium in the goods market and the money market

An increase in government purchases or a cut in taxes would increase expenditure on goods and services and therefore shift the IS curve. Additional government spending (or more tax cuts) increases expenditure on goods and services, which would cause more production. At the original interest rate, output is higher, causing a higher demand for money than what is available. Equilibrium may be achieved if there is an increase in the interest rate

Crowding out occurs when the demand for money is insensitive or inelastic to interest rate adjustments or changes. This results to a vertical LM Curve. With a vertical LM curve, any shift of the IS curve affects only interest rates. The level of output or income will remain unchanged. Under a crowd out, a fiscal expansion shifts the IS curve to the right, and would result to a higher interest rate at equilibrium.

References
The Hicks-Hansen IS-LM Model. http://CEPA.NEWSCHOOL.EDU. Retrieved 2008/07/05