ASSIGNMENT OF CENTRAL BANKING

Topic:

"Circle flow of money 1: between households and business 2: between saving and investment"
Submitted to:
Ma'am Ayesha saleem

Submitted by:
M.Basharat Hafiz Usman M.Zia Umar Ali Awais Khan Hafiz Zeeshan M.Ali Raza (125) (113) (105) (135) (116) (134) (145)

Semester:
5th semester (Morning)

Department of BBA (Banking and Finance) GC, University Faisalabad.

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Circular flow of money

An exchange is a voluntary agreement between two people in which each gives something to the other and gets in return something that he considers of greater value. When John and Jim exchange baseball cards, John gets cards that he considers more valuable than those he gives to Jim, and Jim gets cards that he considers more valuable than those he gives to John. Unless both sides of the exchange feel that the exchange benefits them, the exchange will not take place. Because both sides benefit, exchange is, in the terms of game theory, a positive-sum game. An alternative to interaction by exchange is interaction that involves coercion. With coercion, the actions of one side are not voluntary but forced. If Jim takes baseball cards away from John and threatens to beat him up if he complains, we have interaction based on coercion. Economics focuses almost exclusively on interactions based on exchange and ignores those based on coercion. As a result, it has much more to say about markets than about government, which is the primary agent of coercion in society. People engage in exchange to attain goals. Exchange is not just taken; in order to get, one must give. People must do things that they do not want to do in order to get things that they desire. The unpleasant part of this process is work and production, and the pleasant part is consumption. Work and production are not pursued for their own sakes, but only because without them we cannot consume. This division of economic life which, Frank Knight called the Wheel of Wealth, but which is now more commonly known as circular flow of money. Circular flow of money describes how a market economy works. A market economy is one in which individuals influence directly what is produced, marketed, and consumed. Individuals do this by spending money on what they want. This then directs producers to produce goods and services.

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Between household and business circle:

According to circular flow of income in a two-sector economy, there are only two sectors of the economy, i.e., household sector and business sector. Government does not exist at all; therefore, there is no public expenditure, no taxes, no subsidies, no social security contribution, etc. The economy is a closed one, having no international trade relations. Now we will discuss each of the two sectors.

(i)

Household Sector: The household sector is the sole buyer of goods and services,
and the sole supplier of factors of production, i.e., land, labour, capital and organisation. It spends its entire income on the purchase of goods and services produced by the business sector. Since the household sector spends the whole income on the purchase of goods and services, therefore, there are no savings and investments. The household sector receives income from business sector by providing the factors of production owned by it.

(ii) Business Sector: The business sector is the sole producer and supplier of goods and services. The business sector generates its revenue by selling goods and services to the household sector. It hires the factors of production, i.e., land, labour, capital and organisation, owned by the household sector. The business sector sells the entire output to households. Therefore, there is no existence of inventories. In a two-sector economy, production and sales are thus equal. So long as the household sector continues spending the entire income in purchasing the goods and services from the business sector, there
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will be a circular flow of income and production. The circular flow of income and production operates at the same level and tends to perpetuate itself. The basic identities of the two-sector economy are as under Y=C Each payment transaction also has two aspects: the spending of the purchaser is the income of the seller. This dual nature of money transactions is the basis for the NIPA's double-entry accounting, and for the basic Keynesian/NIPA macro equation: Spending = Income. They are conceptually equal "by definition." And since NIPA output is measured by what is spent for it, Output = Income. Where Y is income C is consumption So the circular flow of economic activity is really two flows--a flow of money, and a flow in the opposite direction of commodities of value. Along the lower branch of the circular flow, expenditures flow from households to businesses. But the goods and services that those expenditures pay for--the commodities that households value--flow in the opposite direction, from businesses to households. Along the upper branch of the circular flow, incomes flow from businesses to households. The counter flow along the upper branch is the flow of factors of production--the labor time of workers, the rental of capital and land, and the returns to risk-bearing, entrepreneurship, and management. In a two-sector macro-economy, if there is saving by the household sector out of its income; the goods of the business sector will remain unsold by the amount of savings. Production will be reduced and so the income of the households will fall. In case the savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled by investment. Through investment, the equilibrium level between income and output is maintained at the original level. It is illustrated in the following figure:

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The equilibrium condition for two-sector economy with saving is as follows: Y=C+S Where Y is Income C is Consumption S is Saving I is Investment Or Y=C+I Or C+S=C+I Or S=I

MARKETS:
There are two types of markets in the circular flow of goods and services. The resource market is where businesses purchase what they use to produce goods and services. Resources are in the form of labor, natural resources, capital, and entrepreneurship, all of which are supplied by households. If, for example, a business wants to build a small plant to produce electronic equipment, it must have land on which to build the plant. In the process of building the plant, it uses human laborers who in turn use natural resources to construct the building. Capital to complete the building comes ultimately from households, usually by means of some type of financial institution that lends money to the entrepreneurs (who also come from households) to construct the electronics plant.
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Product markets are where goods and services are sold. In the case of the plant that produces
electronic equipment, the outlets for its products might be retail stores. Members of households purchase the equipment for their own use in the household. Pieces of electronic equipment are purchased by the households that also provided the resources that made it possible to build the product. The outside circle of the process shown in Figure 1 has been completed. In the reverse direction is the flow of spending. Beginning with households, the individuals therein spend money for the purchase of goods and services that are provided by businesses. In our example, the purchase is of a finished piece of electronic equipment. The money that is spent on the equipment flows from households to the business, making it possible for the business to sustain operations. To sustain operations, the business must pay workers and purchase resources. Money continues to flow through the business into the resource markets. Bear in mind that one of the vital resources for the operation of a business is human resources, which are supplied by households. Some of the money that passes through the business goes back into the households as pay for the use of the human resources. Once again, the circular flow is complete: Money that came from households through the purchase of electronic equipment passes back to households in the form of wages. The money flow is more extensive than just wages, as shown in Figure 1. Households do not spend all their wages on goods and services. Some of the money goes into banks, financial investments, real estate, and numerous other places. From those resources, households expect to receive interest or rent as the resource is used. Banks and other financial institutions do not simply hold the money that is deposited by the householdsinstead; they use it to provide capital for building electronic plants and for numerous other reasons. The money flows back and forth through the circle. The two flows of income and expenditures are equal. Expenditures on products are ultimately someone's household income. Income that flows into households is expended in some way, either for goods and services or to purchase stock in companies, CDs, land, or another type of investment.

LIMITATIONS:
The circular flow model presented here is an accepted way to show the flow of goods and services in a market economy. In a mixed economy, the government plays an important role as well, but this is not shown in the circular flow model. Local, state, and federal governments also produce, or cause the production of, goods and services. Schools, highways, water-treatment plants, parks, and other facilities are examples of government spending. Governments take part of household incomes in the form of taxes, but they also inject money back into households in the form of wages. Some of that money goes back to the government in the form of taxes and still more goes into other places. The government has considerable control over the economy, which in turn affects production, employment, and economic growth. If interest rates go up, households will purchase fewer goods Page 6 of 10

and services. If interest rates go down, households will spend more. This spending adds to or takes away from businesses' operations and the amount of goods and services being produced. Governments can influence the mix of goods and services offered to households. Good examples, although they might seem rather extreme, are when the government ordered the breakup of the Bell Telephone System and later of Microsoft Corporation because it was determined that they violated antitrust legislation and had become monopolies. This kind of breakup affects business operations and households. The model that is shown in Figure 1 could also be influenced by pricing factorsthat is, the laws of supply and demand. The model does not take into consideration changes in prices or how prices are determined. Nor does it take into consideration how businesses choose the products or services they produce and market. Another limitation of the model as presented here is that not all the products and services offered by businesses go to the households that provide the resources. For example, some of the electronic equipment produced in the plant described earlier might be exported to another country. In that case, the goods and services leave the circular flow and the resources to pay for the goods and services come from outside the circle. It might be easier to simplify the explanation and include all households and all businesses in the world, but most economists would not agree with that simplification. While readers should be aware of the influence that government, exporting and importing, and pricing and production has on businesses and households, it is not necessary to alter the circular flow model. It remains a viable illustration of what happens in a macroeconomic sense without microeconomic influences. It is also considered by some to be a limitation when money leaves the circular flow to be invested in savings, stocks, bonds, and other financial investments. However, the discussion here assumes that the money that is invested does not really leave the circle, but rather is passed on as a resource to others. It is true that some money does leave the circle because banks and other financial institutions are required by law to maintain a certain amount of money on deposit. And because some individuals in households don't trust banks or other financial institutions, they use the "coffee can" approach to saving their moneythey simply keep their savings at home.

Between saving and investment circle:

Savings: On the average, households spend less each year than they receive in income. The
portion of household income that is not used to buy goods and services or to pay taxes is termed Saving. Since there is no government in a two-sector economy, therefore, there are no taxes in this economy. The most familiar form of saving is the use of part of a households income to make deposits in bank accounts or to buy stocks, bonds, or other financial instruments, rather than to buy goods and services. However, economists take a broader view of saving. They also consider households
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to be saving when they repay debts. Debt repayments are a form of saving because they, too, are income that is not devoted to consumption or taxes.

Investment: Whereas households, on the average, spend less each year than they receive in
income, business firms, on the average, spend more each year than they receive from the sale of their products. They do so because, in addition to paying for the productive resources they need to carry out production at its current level, they desire to undertake investment. Investment includes all spending that is directed toward increasing the economys stock of capital.

Financial Markets: As we have seen, households tend to spend less each year than they
receive in income, whereas firms tend to spend more than they receive from the sale of their products. The economy contains a special set of institutions whose function is to channel the flow of funds from households, as savers, to firms, as borrowers. These are known as financial markets. Financial markets are pictured in the centre of the circular-flow diagram in the above figure.

Y=C+I+G

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Where Y is Income, C is Consumption, I is Investment G is Government Spending. In the above diagram 1: The household sector is supplying factors of production to the factor market. 2: Business sector demands the factors of production from factor market. 3: Inputs are used by the business sector, which produces goods and services that are purchased back by the households and the government. 4: Personal income after tax or disposable income that is received by households from business sector and government sector is used to purchase goods and services and makes up consumption expenditure (or C). 5: The money spent in the product market is the market value of final goods and services (or GDP). That money goes to business sector that pays it back in the form of wages, rent, profits and interests. 6: The household pay the taxes to the government, through which it make payment to the households. 7: The businesses pay taxes to the government, through which it gives subsidies to the businesses. 8: The households, if have savings, give it to financial institutions which invest in the businesses and earn the interest and payback the interest to the households.

Note that government spending (G) includes its buying of labour from factor market, buying of
goods and services from product market, and transfer payments to the household sector. Transfer payments are payments the government makes in return for no service, for example, welfare payments, unemployment compensation, pension, etc. The government collects its money in the form of tax, which makes up most of the government revenue. But the government does not always balance their budgets. The government always tends to spend more than it takes in as taxes. The federal government almost always runs a deficit. The government deficit must be financed by borrowing in financial markets. Usually this borrowing takes the form of sales of government bonds and other securities to the public or to financial intermediaries. Over time, repeated government borrowing adds to the domestic debt. The debt is a stock that reflects the accumulation of annual deficits, which are flows. When the public sector as a whole runs a budget surplus, the direction of the arrow is reversed. Governments pay off old borrowing at a faster rate than the rate at which new borrowing occurs, thereby creating a net flow of funds into financial markets.

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