The Circular Flow of Income and Expenditure
The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world.
The Circular Flow of Income and Expenditure
Firms hire factors of production from households. The blue
flow, Y, shows total income paid by firms to households.
The Circular Flow of Income and Expenditure
Households buy consumer goods and services. The red
flow, C, shows consumption expenditures.
The Circular Flow of Income and Expenditure
Households save, S, and pay taxes, T. Firms borrow some of
what households save to finance their investment.
The Circular Flow of Income and Expenditure
Firms buy capital goods from other firms. The red flow I
represents this investment expenditure by firms.
The Circular Flow of Income and Expenditure
The Government buys goods and services, G, and borrows
or repays debt if spending exceeds or is less than taxes
The Circular Flow of Income and Expenditure
The rest of the world buys goods and services from us, X and
sells us goods and services, M—net exports are X - M
The Circular Flow of Income and Expenditure
And the rest of the world borrows from us or lends to us
depending on whether net exports are positive or negative.
The Circular Flow of Income and Expenditure
The blue and red flows are the circular flow of income and
expenditure. The green flows are borrowing, lending, and taxes.
The Circular Flow of Income and Expenditure
The sum of the red flows equals the blue flow.
That is: Y = C + I + G + X - M
Expenditures
• Expenditures are purchases of goods and services.
• Expenditures are
–
–
–
–
Consumption expenditure (C)
Investment expenditure (I)
Government spending (on goods and services) (G)
Net Exports (X-M)
• Exports (X)
• Imports (M)
Expenditures equal Income
• Expenditures= C + I + G + X – M
• All expenditures become someone’s
income so
• Y (income) = C + I + G + X – M
Government
• Government spending:
– Goods and services (G)
• Roads, health care, education, helicopters, police officers salaries,
judges salaries.
• Government revenue:
–
–
–
–
Taxes
(Income from Crown corporations)
(Tariffs)
Less Transfers to persons (part of net taxes)
• GST rebates, unemployment insurance, pensions, subsidies
• Interest on the debt (substantial)
• NOTE: The gov’t is not buying services, so transfers are not an
expenditure.
Budgetary Deficits and Surpluses
• Spending
 Goods and services (G) +
Transfers to persons (Tr)
• Revenue
 Taxes (Tx)
• Net Taxes
 Tx – Tr = NT
• Surplus
 G + Tr < Tx
 G < Tx – Tr
 G < NT
• Deficit
 G + Tr > Tx
 G > Tx – Tr
 G > NT
Savings and Investment
• Investment is financed by savings
• Savings have three sources:
– Savings by households
• The part of income households do not spend on
consumption or net taxes.
• (S = Y - C - NT)
– Savings by governments
• NT – G = savings
– Savings of foreigners
• M – X = foreign borrowing
STOCKS AND FLOWS
• FLOWS
– Income : the goods and
services produced each year
– Deficits: The excess of
spending over income each
year
– Investment: Goods produced
to be used in production each
year
– Surpluses: The excess of
revenue over expenditures
each year.
• STOCKS
– Wealth: All the goods a
person owns. Wealth is the
sum of past net saving.
– Debt: the sum of all past
deficits less all past surpluses
– Capital: All the investment
goods owned. Capital is the
sum of past net investment