THE CIRCULAR FLOW OF ECONOMICS ACTIVITIES

Within the economy, basic economic activities take place. These include production,
consumption, employment and income generation. They take place through the
interrelationship that exists between two economic units: the household which is the
basic consuming unit; and the firm which is the basic producing unit.
Let us describe these important economic activities. Production is the use of economics
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 resource owners. The landowner earns rent,
the capitalist earn 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 flow is. A flow is
defined as a quantity measured over a particular period of time. This term is in contrast
to the word stock, which is defined as a quantity measured as of given point in time. For
example, my money in the bank as of today is 10,000 pesos. Tomorrow, this amount
may change; it decreases when I withdraw and increases when I deposit more funds.
Water in a tank is another example of stock. Now, when I turn on the faucet and the
water starts to get into the tank, this is a flow of water. This flow naturally changes the
stock of water in the tank.
The concepts of stock and flow measurements are essential in understanding the
economic variables of wealth and income. Wealth is anything of value owned. It may
consist 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 you mother buys a lotto ticket and it wins, your wealth
increases by the amount of her winnings.
Income is a flow. It is rate of 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 decrease this stock.
Economic Model of Production
The flow of goods and services moves in a clockwise direction. This we can see in the
following graph.
Figure 2.1
The Circular Flow of the Production Process

ECONOMICS RESOURCES

(Land, Labor, Capital)

HOUSEHOLDS PRODUCING UNITS

(FIRMS)

GOODS & SERVICES

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We see the households delivering economic resources to the business firms for use in
production. It is because these households are the resources 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 takes place, another 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.
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 at home.
Some firms are raw material 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.
Figure 2.2
Circular Flow of Goods among Production Units

Raw Materials

Raw Material Intermediate Good

Firm Firm

Consumers

Intermediate
Goods
Final Goods
Final Good
Firm
The figure above shows strictly the relationships among the different firm. It is
incomplete because it does not show the role of the household in production as
resource owners. Let us now add this in the figure.
Figure 2.3
Interrelation between Production Units and Households
RESOURCES RAW MATERIAL FIRM

HOUSEHOLDS RESOURCES INTERMEDIATE GOOD FIRM

RESOURCES FINAL GOOD FIRM

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Integrating figures 2.2 and 2.3, we now have the complete picture.
Figure 2.4
The Circular Flow of Goods and Income among Producers and Households

FINAL GOODS

MONEY PAYMENT FOR PURCHASE OF FINAL GOODS

FINAL GOOD FIRM
RESOURCES

MONEY PAYMENT FOR RESOURCES

HOUSEHOLDS RESOURCES
INTERMEDIATE GOOD FIRM
MONEY PAYMENT FOR RESOURCES

RESOURCES
RAW MATERIAL FIRM
MONEY PAYMENT FOR RESOURCES

Economic Model of Income and Consumption

The flow of physical goods is normally accompanied by a flow of income. In figure 2.4
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 counter clockwise direction. Let’s illustrate this in figure 2.5.
Figure 2.5
The Circular Flow of Income

Income Flow of Wages, Interest, Rents

HOUSEHOLDS PRODUCING UNITS

Purchase of Goods & Services

The flows of income and consumption expenditures are flows which involve financial
transactions since they involve the payment of money. When economic resources are
delivered by the households to the business firms, income is generated in the form of
wages, rents, and interests 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 inter-firm transactions in production. We will now
show this financial flow.

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 Figure 2.6
Circular Flow of Income among Producing Units

MONEY PAYMENTS FOR RAW MATERIALS

RAW MATERIAL INTERMEDIATE GOOD

FIRM FIRM
Money Payments for
Intermediate Goods

FINAL GOOD FIRM

Money Payments for
Final Goods

HOUSEHOLDS
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 of income is created.
In figure 2.7, what we see in simplified model, showing only the household and the firm.
Let us see what happens in the flow when we add 2 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 the factories, borrowing 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
purchases.
Figure 2.7
Circular Flows of Physical Goods and Money Income

Purchase of Goods & Services

Economic Resources

HOUSEHOLDS PRODUCING UNITS

Money Payments (Rents, Wages, Interests)

Goods and Services

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 Figure 2.8
The Circular Flow of Goods and Income of Households and Firms,
With the Government and Foreign Countries

GOVERNMENT
Wages, Transfer Payments Purchases of G/S

Taxes Purchases of Goods and Services Taxes

Economic Resources

HOUSEHOLDS PRODUCING UNITS

Income Payments (Rents, Wages, Interests and Dividends)

Goods and Services

Money payments for Money payments for

Imports Exports
FOREIGN COUNTRIES
An open economy like the Philippines maintains trade relations with other countries.
First, it sells goods to other countries, in the form of exports. The Philippines main
export products, are mostly agricultural, like coconut, sugar and bananas. For these,
foreign countries make payments to the business firms which sell to them. In turn, the
Philippines also buy from other countries goods and services called imports. Among the
important imports of our country are oil, machinery, and manufacturing 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. That goods, resources, and money payments will flow as long as households
continue to consume, and as long as firms continue to produce.
2. That since goods and resources flow in 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 spending in the economy. Generally, a peso spending will not result
in an equal amount of income, but in a higher amount. The multiplier, in effect,
increases the resulting income depending on the consumption behavior of the people.
Inflow and Outflows
Consumption is the mainstream of the circular flow. If within the year, the business
firms produced a total of 50 billion pesos worth of goods and services, it would follow
that the income of households would total 50 billion pesos and their spending would be
50 billion pesos. 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

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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 from the stream.
The existence of the government in the model, necessitates the study of the payments
that households have to pay the government on their income. When household pay
taxes, the effect is to lessen their money income and therefore determine the amount
available for consumption spending, that is, disposable income.
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 decreases relative to the
amounts shown in schedule 1. When taxes are increase to 150, the amounts for
consumption spending further decrease. Taxes therefore decrease the level of economic
activity in the flow and constitute our second outflow.
Table 2.1
Schedules of Income, Taxes, Consumption, and Savings
(In Billions)
Schedule 1 Schedule 2 Schedule 3
No Taxes Taxes: P100 Taxes: P150
Income Consumption Savings Disposable Consumption Savings Disposable Consumption Savings
Income (Y - T) Income
300 300 0 200 200 0 150 160 (10)
340 330 10 240 230 10 190 190 0
380 360 20 280 260 20 230 220 10
420 390 30 320 290 30 270 250 20
460 420 40 360 320 40 310 280 30
500 450 50 400 350 50 350 610 40
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 is investment. If investment is equal to savings,
it offsets the outflow caused by the savings of households.
When the government collects the payments made by households in the form of taxes,
the government uses these collections to defray expenses such 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.

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When our country purchases goods from other countries, it is because it expects these
countries to reciprocate by buying its locally produced goods. When our country 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.
Figure 2.9
The Circular Flow of Economic Activity reflecting the Outflows and the Inflows

Purchases of goods and services

Economic Resources

HOUSEHOLDS PRODUCING UNITS

Income payments of Wages, Rents and Interests

Goods and Services

IMPORTS Foreign Countries EXPORTS

TAXES Government EXPENDITURES

SAVINGS Banks INVESTMENTS

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
consumptions, savings, taxes 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 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 the trade policy. The government applies the policies in accordance with its
goal 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.



“If there is any one secret of success, it lies in the ability to get the other person’s point of
view and see things from his angle as well as from your own.”
 Henry Ford