Circular Flow Model and
Economic Activity
• The circular flow model of the economy
illustrates how the Australian economy works
and how its different parts are interrelated.
• Additionally, it identifies some of the
macroeconomic variables affecting our
countries economic conditions.
Sectors in Australia’s Economic System
The household sector
• This sector includes nearly 22 million consumers
or spenders, making up Australia’s entire
population. These households also supply or sell
resources to the business sector.
The business sector
• The business sector consists of all types of firms
(e.g. sole traders, partnerships, public companies)
that supply or sell goods and services.
Sectors in Australia’s Economic System
The financial sector
• The financial sector consists of organisations like
banks, building societies, the stock exchange and
life insurance companies. These institutions
collect or borrow household savings from
individuals and lend these as credit to businesses
wanting to undertake expansion through
investment spending involving the purchase of
new plant and equipment.
Sectors in Australia’s Economic System
The government sector
• The government sector includes the activities of
the federal, state and local governments. It
collects various types of tax revenue from those
earning income and then uses this to help pay for
government spending on the provision of goods
and services for the community (e.g. public
roads, health, education, transport and housing).
Sectors in Australia’s Economic System
The overseas sector
• The overseas sector involves spending on imports
of goods and services by Australians, and
spending by overseas countries on our exports of
goods and services.
Circular Flow of Economic System
Total Production of Goods and Services (GDP) = C + I + G1 + G2 + (X – M)
Income (wages, rent, dividends)
Household Sector
Business Sector
Supply resources (natural, labour, capital)
L
E
A
K
A
G
E
S
Private Consumption Expenditure (C)
Government
Sector
Taxation (T)
Gov’t Spending
(G1 and G2)
Savings (S)
Financial
Sector
Investment (I)
Imports (M)
Overseas
Sector
Exports (X)
I
N
J
E
C
T
I
O
N
S
Aggregate Demand
• The total amount of
expenditure on all goods and
services produced in Australia
in a given year.
Aggregate Demand
AD = C + I + G1 + G2 + (X – M) = GDP
C = Private Consumption expenditure (60%)
I = Private Investment expenditure(20%)
G1 = Government Consumption expenditure
(17%)
G2 = Government Investment expenditure (3%)
X (22%) – M(18%) = Net exports (4%)
AD = C + I + G1 + G2 + (X – M) = GDP
• C: Private Consumption expenditure: household
spending on all goods and services. Durable goods (long
lasting) and Non – Durable (one use) eg food)
• I: Private Investment expenditure. Businesses invest in
(purchase new) capital goods to assist in the production
process.
• G1 : Government Consumption expenditure (Wages,
stationery, running costs)
• G2 : Government Investment (Capital) expenditure
(Building hospitals, roads, schools, buying equipment
etc)
• X – M: Exports minus Imports. We receive money on
the sale of exports Australia produces and we subtract
items of C, I, & G that are imported.
Effect of AD on Economic Activity
• When AD grows strongly firms will experience
increased sales, increased orders and falling
amounts of stock (inventory) or unsold goods
and services.
• Businesses will respond by expanding their
production or output supplied provided there are
available resources
• This will lead to decreased unemployment
• There will be an expansion in the level of
economic activity.
Effect of AD on Economic Activity
• When AD slows firms will experience falling Sales and
rising amounts of stock (inventory) or unsold goods and
services.
• Businesses will respond by cutting their production or
output supplied to prevent further overproduction.
• Firms may discount prices of unsold stock which may
lead to lower levels of inflation
• Firms may reduce workers hours or lay off some
workers.
• This will lead to increased unemployment
• There will be an contraction in the level of economic
activity which may lead to a recession.
Aggregate Demand Factors
• Aggregate demand factors are the influences
that determine the cyclical level of spending of
AD activity.
Factors Affecting AD
•
•
•
•
•
•
•
•
•
•
Household disposable income
Interest rates
Consumer confidence
Business confidence
Overseas world economic growth
Exchange rates
Terms of trade index
Credit growth
Population Growth
Budgetary policy
Disposable Income
• Disposable income represents the money
available for spending after personal tax has been
deducted.
• If income tax falls, disposable income increases.
• Consumers are likely to increase their spending
on goods and services
• ↑ private consumption expenditure (C)
• ↑ AD
• ↑ economic activity
Interest Rates
• Interest rates are both the cost of borrowing and
reward for savings
• An decrease in interest rates will decrease debt
repayments on mortgages and other loans. An
decrease in interest rates will also discourage saving.
• ↑ private consumption expenditure (C)
• In addition, lower interest rates may encourage
businesses to borrow to finance investment in new
capital
• ↑ private investment (I)
• ↑ AD
• ↑ Economic activity
Consumer confidence
• Consumer confidence measures the level of
household optimism about future employment
and income and the state of the economy.
Business confidence
• Business confidence measures a firms
expectations about future sales and profits
Economic Activity Overseas
• Economic growth overseas influences the
demand for Australia’s exports.
• An increase in the GDP of a trading nation such
as China means that more production and
expenditure is occurring in China.
• This will lead to more expenditure on Australia’s
exports.
The Exchange Rate
• The exchange rate is a measure of one nation’s
currency against another nation’s currency.
• An increase in the value of the AUD against another
nation’s currency is known as an appreciation.
• An appreciation of the AUD makes our exports more
expensive for overseas people to purchase
• ↓X
• An appreciation of the AUD makes imports cheaper
for Australians to purchase
• ↑M
• ↓(X – M)
• ↓AD
Aggregate Supply
• The total value of goods and services
that business in Australia plan on
selling in a given time period.
Aggregate Supply Side Factors
• Cost of production
– Wages, fuel prices, import prices, cost of raw
materials, interest rates on business loans
• Number of productive resources
– Increased size of the labour force, higher
participation rates, increased land resources,
mineral discoveries
• Quality of resources
– Growth in labour and capital productivity
(output/input), better training and education
programs, technological progress (ICT)
Aggregate supply
• Aggregate supply is affected by policies
and actions of economy
• Labour
• Business
• Government.
in relation to the factors of production in an
available in an economy (the “supply”)
Labour Productivity
• Labour productivity is a measure of the
efficiency of labour resources, It measures the
amount of output produced for each given
labour input, usually hours worked.
• An increase in Labour productivity will
increase aggregate supply of inputs into the
production process. (more output for the same
time/cost)
Government
• Aggregate supply is targeted by government
"supply side policies" which are meant to increase
productive efficiency and hence national output.
• Some examples of supply side policies include:
education and training, research and development,
supporting small/medium entrepreneurs, decreasing
business taxes, making labour market reforms to
diminish frictions that may hold down output, and
investing in infrastructure.