Unit 3

UNIT 3:
HOW THE ECONOMY WORKS

Upon completion of this unit you will be able to:
• distinguish between households and businesses and

show how their activities interrelate
• describe the role of the government and show how
it interacts with households and businesses
• describe the role of the foreign sector and show
how it interrelates with the domestic economy
• describe how the financial sector fits into the
circular flow
• provide a macroeconomic interpretation of the
circular flow model
1. IMPORTANT TERMS
 Demand: Quantity of a good or service that buyers are

willing and able to purchase per period of time at a
specific price.
 Supply: Qquantity of a good or service that sellers are
willing and able to ell per period of time at a specific
price.
 Price: What buyers and sellers regard as the value of a
product or service. Prices are determined by the
interaction of demand and supply.
 Market : Any contact or communication between
potential buyers and potential sellers of a product or
service. A market has the elements of demand, supply
and price.
1. IMPORTANT TERMS
 Market : Any contact or communication

between potential buyers and potential
sellers of a product or service. A market has
the elements of demand, supply and price.
 Markets are key to the functioning of
modern economic system.
 They provided signals to producers for “what
to produce?”, “how much to produce?” and
“for whom to produce?”
 They provided signals to consumers for “what
to consume?” and “how much to consume?”
Price is the signal that markets provide.
TWO TYPE OF MARKETS
1. IMPORTANT TERMS (CONTINUE)
 Goods market : Market where goods and

services are exchanged. Businesses are the
suppliers of goods and services and households
are the demanders of goods and services on these
markets.
 Market for factors of production: Includes
markets for labour, capital goods, natural
resources and entrepreneurship.
Businesses are the demanders of factors of
production while the households are the
suppliers of factors of production on
these markets.
TWO SECTOR CIRCULAR FLOW
2. THE TWO-SECTOR CIRCULAR
FLOW DIAGRAM: HOUSEHOLDS
AND FIRMS
• Closed Economy: The operation of a market economy
without government intervention or foreign trade
illustrated by a two-sector circular flow diagram.
• The circular flow model shows you how the economy’s
resources, money and goods and services flow between
households and businesses through factor markets and
product markets.
• The outside flow is called the real flow and consists of
production.
• The inside flow is called the money flow and consists of
income and expenditure.
2. THE TWO-SECTOR CIRCULAR
FLOW DIAGRAM: HOUSEHOLDS
AND FIRMS
• The model is called a circular flow model, because

households use the money they receive from their
supply of resources to purchase goods and
services from businesses.
• Businesses, in turn, use the money that they
receive from households to pay for their factors
of production.
• Stream A:
• Households are the owners of most of the factors
of production and they sell these resources to the
businesses on the market for production factors.
• Stream B:
• When households sell their factor services to the
firms, they receive income.
• In economics we use the letter ‘Y’ to indicate
income.
• Stream C:
• The businesses use these factors of production to produce
goods and services that they sell to households on the
product markets.
• There is a flow of goods and services from businesses to
households.
• Stream D:
• The households use the income that they receive for their
factor services to purchase the goods and services.
• This flow of money from households to the firms is called
expenditure.
3. THE FOUR-SECTOR CIRCULAR FLOW
DIAGRAM AND THE ROLE OF FINANCIAL
INSTITUTIONS
3. THE FOUR-SECTOR CIRCULAR
FLOW DIAGRAM AND THE ROLE OF
FINANCIAL INSTITUTIONS
 Stream A, Stream B, Stream C and

Stream D represent the same flow as in a 2
sector circular flow explained earlier.
 Stream E:
 This stream flows in both directions.
 The government buys goods and services on the
goods market and in turn sells public goods on this
market.
INSTITUTIONS
 Stream F:
 This stream also flows in both directions.
 The government pays for the goods and services purchased
on the goods market but it also receives payment for the
public goods it sells on the goods market.
INSTITUTIONS
 Stream G:
 These flows represent transfer payments from the government to both
households and firms.
 The benefits to households are payment such as old-age pensions as
well as disability or unemployment benefits for those who have lost
their jobs.
 The benefits to businesses are in the form of subsidies.
 Subsidies help to reduce the prices of certain essential goods so that
poor households can afford them.
 These transfer payments are not exchanged for goods and services,
in other words, the government gets nothing in return.
INSTITUTIONS
• Stream H:
• The government receives revenue from households
and businesses in the form of direct and indirect
taxes.
• Stream I:
• This stream flow in both directions.
• Production factors flow from Namibia to foreign
countries and from foreign countries to Namibia
through the factor market.
INSTITUTIONS
• Stream J:
• This stream also flows in both directions and represent
payment for production factors from Namibia to foreign
countries and from foreign countries to Namibia.
• Stream K:
• This shows the flow of goods and services from Namibia to
foreign countries (exports) and from foreign countries to
Namibia (imports) through the goods market.
INSTITUTIONS
• Stream L:
• This represents payment for imports and exports.
• When we pay for imports, money is withdrawn from
the circular flow and we refer to it as leakages.
• Payments for exports add money to the circular flow
and we refer to that as injections.
• A financial institution is a business whose primary activity is
buying, selling or holding financial assets.
INSTITUTIONS
 Stream M:
 Financial institutions such as banks are intermediaries (a
kind of middleperson) between borrowers and lenders.
 Both households and firms keep their savings in these
institutions which then give loans to firms that wish to
invest.
 When firms buy capital goods we call it investment spending.
Financial institutions therefore provide credit to households
(consumers) and businesses (producers).
 Stream N: Interest payments from households and
businesses for the credit provided.
4. A MACROECONOMIC
INTERPRETATION OF THE CIRCULAR
FLOW MODEL
 Total expenditure consists of all expenditures made in the

economy during a specific year. Total expenditure is the sum of
the following:
 Total consumption expenditures by households (C)
 Total investment expenditures by businesses (I)
 Total government expenditure (G)
 Total foreign expenditures (X-M) that is income from exports
minus expenditures on imports
4. A MACROECONOMIC
INTERPRETATION OF THE CIRCULAR
FLOW MODEL
• We can now formulate the following equation:
• Total spending = C + I + G + (X-M)
(1)
• The value of total production inside the borders of a country
during one year is called the Gross Domestic Product (GDP).
The GDP must therefore be equal to the total spending.
• We can write it as follows: GDP = Total spending
(2)
• Equation (1) and (2) together can be written as follows:
GDP = C + I + G + (X-M)
ACTIVITY 1
1) Indicate whether the following economic

transactions would occur in goods markets or
in factor markets.
a) Retail sales of electronic equipment.
b) The payment of wages to Shoprite employees.
c) Tenants’ rent payments to landlords.
c) Dividends paid to shareholders of firms.
d) Expenditures for movies and soccer events.
ACTIVITY 2
A country had the following statistics for the

year 2017:
•Imports N$1 700
•Exports N$1 400
•Private consumption expenditure N$7 000
•Government expenditure N$2 534
•Investment expenditure N$5 000
a) What is the total value of production (GDP) of this

country if the total spending equals the total value
of production?
KEYWORDS
• Capital goods: Goods such as factories and machines that are used for producing
other goods and services.
• Consumer goods: Goods such as food, clothing and electricity that are sold to
households for consumption and that do not contribute to further production.
• Circular flow model: A graphic illustration of the operation of a market economy.
• Closed economy: A country that has no foreign trade.
• Factor market: A market where factors of production are exchanged for money.
• Goods market: A market where goods and services are exchanged for money.
• Gross domestic product: The market value of all final goods and services
produced inside the borders of a country during a given year.
• Open economy: A country that trades with other countries.
• Transfer payments: Payments made to individuals that are not payments for
goods and services.

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UNIT 3:

HOW THE ECONOMY WORKS

• distinguish between households and businesses and

 Demand: Quantity of a good or service that buyers are

 Market : Any contact or communication

 Goods market : Market where goods and

• The model is called a circular flow model, because

 Stream A, Stream B, Stream C and

 Total expenditure consists of all expenditures made in the

1) Indicate whether the following economic

A country had the following statistics for the

a) What is the total value of production (GDP) of this

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