The Activities of Households and Firms - Term Paper Example

Paper on: THE CIRCULAR FLOW MODEL & THE UK CONSUMER CREDIT CRISIS THE BASIC CIRCULAR FLOW MODEL The economy can be described as a circular flow of income. The key players in any economy are the firms and households. Firms use factors of production (inputs) such as labour, to produce goods and services (output). Households purchase goods and services from and supply factors of production or resources to firms. In the basic model of the circular flow, the activities of households and firms are linked in a number of ways. First, households sell production inputs to firms such as man-hours of work. In return, they receive wages or salaries. Second, firms deliver goods and services to households, receiving appropriate payment in return. In the schematic diagram below, the macroeconomic flows contain two circles: the inner circle which are real flows of goods and services, and the outer circle which are the monetary flows. The inner circle indicates that the exchange of real things is taking place. Households provide factors of production (labor, land, capital, entrepreneurship) to firms, and firms pay by delivering goods and services to households (in the form of wages, rent, interest, and profits). Households receive income from firms and the money then flows back to the firms in the form of consumer spending. Economists use the outer circle, the monetary flow, as the measurement of the transactions that are going on in an economy (Lipsey 1996). Total payments from firms to households constitute household income and measure the value of the factors of production supplied. Total payment from households to firms constitute total spending and measure the value of goods and services produced and purchased. Since all spending must arrive somewhere, income equals spending. The upper flow from left to right mirrors the lower flow from right to left.(The Circular Flow of Income) Finally, when products are exported, the circular flow is broken, as goods leave the circular flow to another country, and the payment of money comes from outside the circle. This will need additions to the model so that injections and withdrawals of factors or resources are included. When a financial intermediary invests in an IOU such as a mortgage instrument from another country, money flows out of the economy in the same manner as an investment abroad. Accordingly, the circular flow model needs to be modified. An elaborated and slightly more complex form of the Circular flow which takes into account the role of government and of the role of financial intermediaries in more detail, as well as the role of the Rest of the World, is shown below: LIMITATIONS OF THE MODEL The circular flow model is a very simplified way of presenting the flow of goods and services in a free market economy However, in a mixed economy like the United Kingdom and many other countries, the government also plays an important role, for governments, like firms, produce goods and services; highways, ports, public parks, hospitals, health infrastructures, schools, and mass housing as well as health and social services are just few examples. In fact, the government is the biggest employer in many countries and pays wages to workers and households, thus injecting money into the economy. At the same time it collects taxes to finance the facilities and services it provides, thereby withdrawing money from the economic stream. The government can also affect businesses through policies, as when big businesses are broken up in the process of enforcing anti-trust laws. What the circular flow model does not show is the fact that governments exercise considerable control and influence over the economy through the policies it promulgates, thus affecting production, employment, welfare, and growth. If the Bank of England, for example, raises interest rates because of inflation or because the economy is overheating, business firms will scale down investments and consumers will purchase less goods and services. If interest rates are reduced, households will spend more instead of saving, and businesses will be encouraged to borrow. The effect of interest rates on spending in turn determines how businesses decide on their levels of production. The central bank may also increase or reduce money supply through its re-discount policies and through open market operations, by buying or selling Treasury securities to the public. Another important consideration is that savings and investments may not always be equal. While households may save through banks and other financial intermediaries, which will in turn funnel these funds to borrowers and other fund users such as the government to finance its deficit or businesses who need more capital for expansion, it is also true that some money becomes or remains dormant due to such reasons as governments legal reserve requirements on deposits, and the decision of some people to hoard money. Further, the role of financial intermediaries in using savings to finance investments such as mortgage instruments, bonds, and other IOUs are also not given appropriate space and emphasis in the model. Background of the Current Credit Crisis The credit crisis that has spread to the UK and other countries started in the United States sometime in August 2007 when massive defaults in mortgage payments occurred in the subprime mortgage sector. A subprime mortgage is one that is normally made out to borrowers with lower credit ratings (below 600) and is charged rates that are higher than a conventional because it has a larger-than-average risk of defaulting on the loan (Investopedia). The most relevant part of the Circular Flow Model in the present credit crisis is the “Rest of the World” Sector. According to the Daily Telegraph, British banks are exposed to billions of British pounds in American subprime mortgages - where expensive home loans were offered to people who could not afford them – because debts were sold on by US investment banks and bought as investments by high street banks in UK. Some British banks also lent directly to poor families in America and also lent money to less credit-worthy consumers in that country. As part of process called globalization, financial deals are easily made across borders and continents. Financial flows from Europe and the rest of the world to the United States such as those related to subprime mortgages and other instruments are executed quickly, in seconds. Within the UK economy, the flow of funds from financial intermediaries is affected by the credit crunch. When banks refuse to lend to homeowners and consumers because of the need to hold on to liquidity, that portion of the circular flow model that pertains to investment and consumption becomes somewhat constricted There can be a cumulative effect that can lead to recession in the future unless the government successfully intervenes. While the government in the circular flow basically shows the fiscal role of spending and taxation its use of monetary policies should be highlighted as well: the injection of funds into the economic system in order to re-stimulate lending. The Bank of England, mimicking what he US Federal Reserve Bank of the United States has done is offering to swap government bonds worth 50 billion pounds ($100 billion) for banks riskier mortgage debt to try to ease the effects of a credit crunch on Britains banking system, to ease pressure on lenders who are still reluctant to lend. Lending, in limited quantities, have been characterized by low credit limits, high spreads and high cost for the consumers. The modified Circular Flow Model can be used to explain and clarify what is taking place in the UK economy as a consequence of the global credit crisis. Consumer Debt in the UK and Germany Parallel to the credit crunch that has affected the UK and other countries is consumer debt in developed countries. With regard to the comparison between the UK and Germany in this regard, the following observations may be made: 1. There was soaring demand for debt in the UK shortly before and after 2000 on the back of rising real estate prices and low interest rates. Homeowners saw their property values triple. In contrast, home prices in most European countries, including Germany, barely moved, mainly because markets were more regulated, housing was more available, and renting was more preferred. Mortgaged debt in the country rose so much that it is now considered to constitute 100 percent of an average household’s disposable income. 2. Consumer spending in the UK has been unrestricted, with regulators standing from the sidelines while Britons engaged in debt-financed spending sprees that caused their cumulative debt to rise to1.4 trillion pounds on loans, credit cards and overdrafts, more than the country’s Gross Domestic Product (GDP). This is greater than that of the United States whose total is less than its $14 trillion GDP. The regulators in Germany (and France) were more restrictive by curbing the explosion of retail lending in that country that followed advertising campaigns and offers of low-interest or no-interest loans and credit cards. 3. The debt-to-income ratio is 1.62 in UK compared to only 1.09 in Germany (1.42 in the United States). --------------------- BIBLIOGRAPHY Colander, DC 2001, Economics, 4th ed., Irwin/McGraw-Hill, New York Investopedia.com accessed on 20 April 2008 Frank, R & Bernanke B 2001, Principles of economics, Irwin/McGraw-Hill, New York, pp. 252 - 254 Lipsey, R.G., Courant, P.N, & Ragan, C.T., 1999. Economics (12th Edition): The Addison-Wesley Series in Economics, New York Mankiw, NG 1998, Principles of economics, The Dryden Press, Orlando, FL, McEachern, WA 1997, Economics: A contemporary introduction, South-Western Publishing, Cincinnati, OH The Circular Flow of Income, accessed 20 April 2008 from http://www.fgn.unisg.ch/eurmacro/Tutor/circularflow_applet.html Read More