A Level Economics 71: The Circular Flow Model

The circular flow model is a simplified representation of how goods, services, and money flow through an economy. It illustrates the interactions between households and businesses and how they participate in the production and consumption of goods and services. The model consists of two main sectors: the household sector and the business sector.

Assumptions of the Circular Flow Model:

1. There are only two sectors in the economy: households and businesses.
2. The economy is a closed system with no external trade or government involvement.
3. All income earned by households is either spent on consumption or saved.
4. Businesses use all their revenue to pay for factors of production, such as labor and capital.

Components of the Circular Flow Model:

1. Households: Households are the owners of resources, such as labor, land, and capital. They supply these resources to businesses in return for income. In the circular flow model, households are depicted as the source of labor and as consumers who purchase goods and services from businesses.

2. Businesses: Businesses are the producers of goods and services. They hire labor and purchase other inputs from households and produce goods and services that are sold to households.

3. Factor Market: The factor market is where businesses purchase the factors of production from households. Households provide labor, land, and capital in exchange for wages, rent, and profits.

4. Product Market: The product market is where businesses sell goods and services to households. Households, in turn, spend their income on purchasing these goods and services.

The Circular Flow and Equilibrium: In an economy, the circular flow reaches equilibrium when the total amount of goods and services produced (output) matches the total amount of goods and services consumed (expenditure) by households. Additionally, equilibrium means that the total income earned by households is equal to the total income spent on goods and services by businesses.

Key Terms in the Circular Flow:

1. Injections: Injections are additions of income to the circular flow of income and spending that do not arise from the normal activities of households and firms. These injections are external to the circular flow and include three main components: investment, government spending, and exports.

2. Withdrawals: Withdrawals are leakages from the circular flow of income and spending. They represent funds that are taken out of the circular flow and do not return as spending on goods and services. There are three main types of withdrawals: savings, taxes, and imports.

Explanations of Injections and Withdrawals:

1. Injections: a) Investment: Investment represents the spending by businesses on capital goods, such as machinery, equipment, and infrastructure, to expand their production capacity and enhance future output. When businesses invest, they inject funds into the circular flow of income, leading to increased economic activity and potential employment opportunities. For example, a construction company building a new factory is making an investment injection into the economy.

b) Government Spending: Government spending refers to the expenditure by the government on public goods and services, welfare programs, education, healthcare, and infrastructure projects. When the government spends, it injects funds into the circular flow, which can boost overall demand and support economic growth. For instance, a government allocating funds to build schools and hospitals is making a government spending injection into the economy.

c) Exports: Exports represent the sale of goods and services produced in a country to foreign markets. When a country exports, it generates income from outside its domestic economy, adding to the circular flow of income. Exports are an important injection as they contribute to a country's economic growth and can create employment opportunities in export-oriented industries. For example, when a country exports cars to foreign markets, it is making an export injection into its economy.

2. Withdrawals: a) Savings: Savings are the portion of household income that is not spent on consumption but set aside for future use or investment. When households save, funds are withdrawn from the circular flow, reducing the overall spending in the economy. While saving is essential for capital formation and investment, excessive saving can lead to reduced demand for goods and services, potentially slowing down economic growth.

b) Taxes: Taxes are compulsory payments made by households and businesses to the government. When taxes are collected, they represent a withdrawal from the circular flow, as the funds are not available for immediate consumption or investment. While taxes are necessary to fund government services, excessive taxation can reduce disposable income and, in turn, lower consumer spending and business investment.

c) Imports: Imports are the purchase of goods and services from foreign markets. When a country imports, it represents a withdrawal from the circular flow as funds flow out of the domestic economy to pay for foreign-produced goods and services. While imports allow consumers to access a variety of products, excessive reliance on imports can affect domestic industries and lead to a trade deficit.

Injections and withdrawals play a crucial role in determining the equilibrium income, output, and expenditure in an economy. Equilibrium occurs when total injections into the circular flow are equal to total withdrawals. Let's examine the impact of injections and withdrawals on the equilibrium:

1. Impact of Injections:

• When injections exceed withdrawals, it leads to an increase in total demand in the economy. This additional demand stimulates businesses to increase production to meet the higher level of expenditure. As a result, output and income increase, leading to a higher equilibrium level.
• For example, if the government increases its spending on infrastructure projects (injection), businesses will experience higher demand for construction-related goods and services. This can lead to increased output and income in the construction industry and related sectors, contributing to an expansion of the economy.

2. Impact of Withdrawals:

• When withdrawals exceed injections, it reduces the total demand in the economy. This reduction in demand may cause businesses to scale back production, leading to lower output and income in the economy.
• For instance, if households increase their savings rate (withdrawal), it reduces their spending on goods and services. This reduction in consumer spending can lead to a decrease in business revenue, leading to lower production and income.

3. Achieving Equilibrium:

• Equilibrium occurs when injections equal withdrawals. At this point, the total demand in the economy matches the total supply, resulting in a balanced level of output, income, and expenditure.
• For example, if the government increases its spending (injection) while also increasing taxes (withdrawal) by an equal amount, the net effect on total demand is zero. This would lead to a balanced equilibrium where total injections equal total withdrawals.

Policy Implications:

• Policymakers often use injections and withdrawals as tools to influence the equilibrium level of income and output in the economy.
• During periods of economic recession or slowdown, policymakers may increase injections, such as government spending on public projects, to stimulate demand and boost economic activity.
• Conversely, during periods of inflationary pressures, policymakers may implement measures to reduce injections, such as raising interest rates or decreasing government spending, to curb excessive demand and control inflation.

In summary, injections and withdrawals are vital determinants of equilibrium income, output, and expenditure in an economy. When injections exceed withdrawals, it leads to higher demand and increased economic activity, while the opposite scenario may result in reduced demand and economic contraction.

Multiplier Effect and Equilibrium:

The multiplier effect refers to the process by which an initial change in injections (such as investment, government spending, or exports) leads to a larger final impact on the equilibrium income and output of an economy. It occurs due to the circular flow of income, where an increase in injections results in increased consumer spending, which, in turn, generates more income for businesses, leading to further spending and income creation. The multiplier effect amplifies the initial injection, creating a larger overall impact on the economy.

Understanding the Multiplier Effect:

1. Initial Injection: Suppose the government increases its spending on public infrastructure projects by $100 million. This additional government spending is an injection into the circular flow of income.

2. Increase in Consumer Spending: With the $100 million spent on infrastructure, construction companies receive more income. The workers employed in these projects now have more money, which they, in turn, spend on goods and services like food, clothing, and entertainment.

3. Increased Business Income: The increased spending by consumers boosts the revenue of businesses producing these goods and services. As a result, businesses experience a rise in their income.

4. Further Rounds of Spending: The businesses, in turn, spend their increased income on paying wages to their employees, purchasing raw materials, and investing in their operations. These payments and investments create additional income for households and other businesses, leading to further rounds of spending and income creation.

5. Multiplier Effect: The process continues in multiple rounds, with each successive round resulting in a smaller increase in spending and income. The total increase in income throughout these rounds is the multiplier effect.

Impact on Equilibrium: The multiplier effect has a substantial impact on equilibrium income and output. As the initial injection leads to additional spending and income creation, the total effect is greater than the initial injection alone. This increase in overall spending raises the equilibrium income and output of the economy.

Example: Suppose the initial government spending injection of $100 million has a multiplier of 2. This means that for every dollar of government spending, the equilibrium income increases by $2.

Initial Injection: $100 million First Round of Spending: $100 million x 2 = $200 million Second Round of Spending: $200 million x 2 = $400 million Third Round of Spending: $400 million x 2 = $800 million

In this example, the final impact of the initial $100 million government spending injection on the equilibrium income is $800 million, which is significantly larger than the initial injection.

Link to Injections and Withdrawals: The multiplier effect is closely tied to injections and withdrawals in the circular flow of income. Injections, such as government spending, investment, and exports, create additional income and spending, which leads to a positive multiplier effect, increasing equilibrium income and output. Conversely, withdrawals, like savings, taxes, and imports, reduce spending and income, leading to a negative multiplier effect and potentially decreasing equilibrium income and output.

In conclusion, the multiplier effect is a powerful concept in macroeconomics, showcasing how initial injections into the circular flow can lead to substantial changes in equilibrium income and output. Understanding the multiplier effect is crucial for policymakers to design effective fiscal and monetary policies to stimulate economic growth and maintain economic stability.

The Rupee's Exchange Rate and Declining Dollar Reserves

 

There is a global debt crisis coming – and it won’t stop at Sri Lanka

Foreign capital flees poorer countries at the first sign of instability. The pandemic and Ukraine war ensure there is plenty of that around writes Jayati Ghosh in The Guardian





This January, even before Sanjana Mudalige’s salary as a sales worker in a shopping mall in Colombo, Sri Lanka, was slashed in half, she had pawned her gold jewellery to try to make ends meet. Ultimately, she quit her job, because the travel costs alone exceeded the pay. Since then, she has shifted from using gas for cooking to chopping firewood, and eats just a quarter of what she did before. Her story, reported in the Washington Post, is one of many in Sri Lanka, where people are watching their children go hungry and their elderly relations suffer for lack of medicines.

The human costs of the crisis only really captured international attention when the massive popular upsurge earlier this month, known as Aragalaya (Sinhalese for “struggle”), led to the peaceful overthrow of President Gotabaya Rajapaksa. His family had ruled Sri Lanka with an iron fist, albeit with electoral legitimacy, for more than 15 years, and is now being blamed by both national and international media for the desperate economic mess the country is in.

But blaming the Rajapaksas alone is too simple. Certainly, the aggressive majoritarianism that they unleashed, along with the alleged corruption and major economic policy disasters of recent years (such as drastic tax cuts and bans on fertiliser imports), were crucial elements of the economic debacle. But this is only part of the story. The deeper and underlying causes of the crisis in Sri Lanka are barely mentioned by most mainstream commentators, perhaps because they reveal uncomfortable truths about the way the global economy works.

This is not a crisis created by a few recent external and internal factors, it has been decades in the making. Ever since its “open economic policy” was adopted in the late 1970s, Sri Lanka has been Asia’s poster boy for neoliberal reform, much like Chile in Latin America. The strategy was the now-familiar one of making exports the basis for economic growth, supported by foreign capital inflows. This led to a significant increase in foreign currency debt, something the IMF and the Davos crowd actively encouraged. 

In the period after the 2008 global financial crisis, as low interest rates in advanced economies led to the availability of cheap credit, the Sri Lankan government relied on international sovereign bonds to finance its own spending. Between 2012 and 2020, the debt to GDP ratio doubled to around 80%, with a growing share of this in bonds. The payments due on these debts kept rising in relation to what Sri Lanka could earn from exports and the money sent back home by Sri Lankans working abroad. The disruptions caused by the pandemic and the war in Ukraine made matters much worse, by causing export earnings to fall and sharply increasing the price of essential imports including food and fuel. Foreign exchange reserves plummeted – but the government had to keep paying interest even when it could not import essential fuel.

Looked at in this light, it is clear that Sri Lanka is not alone; if anything, it’s just a harbinger of a coming storm of debt distress in what economists call the “emerging markets”. The past period of incredibly low interest rates in the advanced economies meant that more funds flowed to “emerging” and “frontier” markets from the richer world. While this found cheerleaders in the international financial institutions (IFIs), it was always a problematic process. This is because, unlike in places such as the EU and US, capital leaves low- and middle-income countries (LMICs) at the first sign of any problem.

And these countries were much more battered economically by the pandemic. Advanced economies were able to provide massive countercyclical measures – think of the UK’s furlough programme – because financial markets effectively allowed and even encouraged them to do so. By contrast, LMICs were prevented from increasing fiscal spending by much – because of those same financial markets, which threatened the possibility of credit downgrades and capital flight as government deficits grew larger. Plus they faced significant declines in export and tourism revenues and tighter balance of payments constraints. As a result, their economic recovery has been much more muted and economic conditions remain mostly dire.

The half-hearted attempts at debt relief, such as the moratorium on debt servicing in the first part of the pandemic, only postponed the problem. There has been no meaningful debt restructuring at all. The IMF bewails the situation and does almost nothing, and both it and World Bank add to the problem through their own rigid insistence on repayments and the appalling system of surcharges imposed by the IMF. The G7 and “international community” have been missing in action, which is deeply irresponsible given the scale of the problem and their role in creating it.

The sad truth is that “investor sentiment” moves against poorer economies regardless of the real economic conditions in specific countries. Private credit rating agencies amplify the problem. This means that contagion is all too likely, and it will affect not just economies that are already experiencing difficulties, but a much wider range of LMICs that will face real difficulties in servicing their debts. Lebanon, Suriname and Zambia are already in formal default; Belarus is on the brink; and Egypt, Ghana and Tunisia are in severe debt distress.

Many countries with lower per-capita income and significant absolute poverty are facing stagflation. Billions of people are increasingly unable to afford a basic nutritious diet, and cannot meet basic health expenses. Material insecurity and social tensions are inevitable.

The situation can still be resolved, but it requires urgent action, especially on the part of the IFIs and G7. Speedy and systematic debt resolution actions to bring in private creditors and other creditors, such as China, are needed, as is IFIs doing their own bit to provide debt relief and ending punitive measures such as surcharges. In addition, policies to limit speculation in commodity markets and profiteering by big food and fuel companies must be put in place. Finally, the recycling of special drawing rights (SDRs) – essentially “IMF coupons” – by countries that will not use them to countries that desperately need them is vital, as is another release of SDRs equating to about $650bn to provide immediate relief.

Without these minimal measures, the post-Covid, post-Ukraine global economy is likely to be engulfed in a dystopia of debt defaults, increasing poverty and sociopolitical instability.

"Over 5800 Foreign Funded NGO's fail to renew their licence on 31 Dec 2021"

 

What price the wisdom of Luke Johnson, when his own company Patisserie Valerie tanks?

Catherine Bennett in The Guardian

The Patisserie Valerie chief should look to himself before lecturing others again

 

Self-styled ‘risk-taker’ Luke Johnson at a branch of Patisserie Valerie in London.


‘Unfortunately,” Luke Johnson wrote recently, “financial illiteracy permeates society from top to bottom. Too many ordinary people do not understand mortgages, pensions, insurance, loans or investing.”

Johnson, the entrepreneur whose biggest asset, Patisserie Valerie, now needs bailing out, was being generous. Even after the 2008 financial crisis confirmed that corporate incompetence warranted unwavering public scrutiny, too many ordinary people remain equally ignorant about the operations and capabilities of business leaders, even those, like Mr Johnson, whose influence extends far beyond his imperilled patisserie company.

Some of us, inexcusably, even struggle with the basic jargon of “black hole”. As in: “The owner of Patisserie Valerie has been plunged into financial crisis after it revealed a multimillion pound accounting black hole.” Is it the same sort of black hole that astonished managers at Carillion, following a “deterioration in cashflows”? Or an industry synonym for the “material shortfall” disclosed by the Patisserie Valerie board, “between the reported financial status and the current financial status of the business”.

Either way, does the black hole’s existence mean that Mr Johnson must also be financially illiterate? Or is that question better addressed to Patisserie Valerie’s finance chief, Chris Marsh, with whom Johnson has worked since 2006? Marsh was arrested by the police, then released on bail.

Regrettably, at the very moment when an ordinary person struggles to comprehend how £28m in May became minus £10m by October, and why one creditor, the HMRC, should be pursuing an unpaid tax bill of £1.4m – and what that tells us about the company’s leadership – it appears that Mr Johnson is taking a break from his weekly newspaper column. Its absence is the more acute, now that its author, expert on subjects such as red tape, Brexit and other people’s incompetence, has also fallen silent on Twitter; and his popular personal website seems, at the time of writing, to have vanished. With luck, it won’t be too long before he is sharing details of his mercy dash on Evan Davis’s The Bottom Line: “Providing insight into business from the people at the top.”

Happily, as others have noted, some of Mr Johnson’s earlier columns have addressed related issues such as, recently, “a business beginner’s guide to tried and tested swindles”. Watch out, he warns, for non-payment of creditors, dodgy advisers and attempts to overcomplicate things, so as to baffle the many people – unlike himself – who “do not understand the technicalities of investing or accounting”.

Inevitably, that widespread ignorance makes it hard to judge how much of Johnson’s wide-ranging, pre-existing advice, which has recently focused on Brexit, we can safely discard as, if not consistently hilarious, worthless. His chairmanship of Patisserie Valerie has, after all, repeatedly been cited, in the same way as Dyson’s profits and Tim Martin’s pubs, as the main reason to listen to him deprecate the EU, with his own achievements (pre-black hole), proving that “this is a great country in which to do business and prosper”.

Although Johnson is no different from other business celebrities, such as Dyson, Branson and Trump, in having parlayed business success into guru status, he has, more unusually, further set himself up as a kind of entrepreneur-moralist, with a biblical line in rebukes. Here he is, against – I think – overpaid government regulators: “Political leaders who want to foster world-beating companies must act decisively and, as with any transformation, slash off the gangrenous limbs without mercy.” Critics of rich people are warned: “Envy is a ruinous trait – as well as one of the deadly sins – and a sordid national characteristic.”
 

Like any half-decent moralist, he alternates rants with hints for personal salvation, through thrift, reliability and, again, financial literacy: “I am surprised how many senior managers I meet cannot read a cashflow statement.”

By way of authority, even Johnson’s less scorching capitalist homilies are littered with references to the usual suspects – Napoleon, Samuel Smiles and Marcus Aurelius – less usually, the scriptures and “the 19th-century philosopher Herbert Spencer”, not forgetting, shamelessly, Ayn Rand. “Those who possess willpower,” Johnson echoes, “seize the day and actively control their destiny.” Less gifted individuals are dismissed as lazy idiots, fools, inferiors who will never get the chance to close down a chain of well-regarded bookshops or, as now, bail out their own patisseries.

That Johnson should, on the back of this stuff, and the cake shops, have risen to yet greater prominence as a notable Vote Leave backer, his blessing sought by Theresa May, is perhaps no more absurd than, earlier, was David Cameron’s promotion of the Topshop brute, Philip Green, or elevation of JCB’s Anthony Bamford (previously fined by the EU). The myth of the disinterested entrepreneur-consultant seems ineradicable.

In Brexit, Johnson and his like-minded entrepreneurs have, however, discovered a yet more rewarding platform on which to portray their regulation-averse interests as a purely patriotic project.

Entrepreneurs, Johnson has written, on this favourite subject, are “the anarchists of the business world. Their mission is to overthrow the existing order.” Every entrepreneur is “a disruptor and a libertarian”, or would be “if the state sets a sensible framework and gets out of the way”. He explains that the word “chancer” properly describes risk-takers like him, who are willing to make mistakes, probably through excessive impetuosity, or as others might think of it, recklessness. “Probably the most common and devastating mistake I’ve made,” he wrote, “is to choose the wrong business partners.” As for abiding by the rules of the game: “It is the nature of risk-takers to be in a ferocious hurry to become successful, which frequently means cutting corners.”

Thus, even before last week’s disclosures about Patisserie Valerie, Johnson’s own columns amounted to the best possible case for ignoring the entrepreneur lobby on Brexit – indeed, on every subject other than their own, risk-taking genius.