Circular Flow of Income - Coursework Example

Macro Economy This paper is aimed at the analysis of the circular flow diagram that links the households to the firms in the economy. Furthermore, the paper discusses how this flow diagram can be used to explain the progress of the United Kingdom in comparison to that of Germany in the last five years. Circular Flow of Income Before doing the comparison of Britain with Germany using the circular flow diagram, it is important to understand the circular flow diagram in detail. The circular diagram, as Pagoso et al. (2008) relates, is the fundamental representation of the economic activity of the major players of an economy, basically the consumers (households) and the producers (firms), the government and the foreign market. The circular flow diagram as seen in Figure 1 (ATTACH FIGURE) shows the link between the households and the firms. The households, according to Pagoso et al. (2008), are the basic consuming units of the economy while the firms are the basic producing units of the economy. Since the production and the consumption are two very important components of the economy, they are the basic features of the circular flow diagram. The household sector in this case applies to everyone. As Amosweb (2010) states, this sector is responsible for the consumption in the economy. Also, it owns the productive resources in the economy that are needed by the firms for the production process to be complete. The business sector (that includes all kinds of firms and business institutions) is responsible for the collection of the productive resources and their conversion into goods and services that can be sold. Its role also includes the buying of the capital goods through investment expenditures. The third sector that is the government sector consists of the government, the federal state, and banks etc. The main role of this sector is to collect taxes and invest in the government expenditures. The forth and the last sector in the flow diagram is the foreign sector. This sector includes as Amosweb (2010) states, everyone outside the domestic country. This sector revolves around the exports and imports of a certain country. Overall, the households basically consume the goods and services provided by the firms. Firms on the other hand are sources of income for the people (households) that work in them. Households pay taxes that are a source of revenue for the government and the governments on the other hand spend on households. Households also save and firms invest. Exports and imports also are the part of the economy. Now the paper will discuss the macroeconomic performance of Britain in the last five years. Britain’s macroeconomic performance According to Duncan (2008), since 2005 the British economy deteriorated. In the first quarter of 2008, the British economic growth fell by 0.3% which was the worst since 2005. Although the saving actually fell and the consumption increased, yet there was no particular affect on the economy except for a decrease in the economic growth. The saving that was done by the people was less than the saving that has been done since 1959. As Duncan (2008) relates, most of the causes of the reduction of the savings were because of the increase in the inflation. Inflation affects the consumption and saving patterns of the people. Increased inflation means that a lot of money has to be given away to get the same amount of goods and services. Therefore people generally believe that their living standards are worsened. That is why they cut on saving and increase the consumption (to get to the previous level of living standards). This proved to be right because the consumption in the economy rose by 1.1 % in the first three months of 2008 as Duncan (2008) analyzes. Even though the consumption had increased the, GDP recorded was the worst one in the three years since 2005. Many reasons may be responsible for this behavior of the GDP. The first one may be because of the imposition of taxes. In the previous years, the taxes in the United Kingdom have increased considerably. Since the taxes serve as a leakage in the flow diagram of the economy, the economic growth and so the GDP is reduced whenever the taxes increase. Although Duncan (2008) argues that the wages of the people have been increased generously, the people are still under the impression that their living standards have decreased. The consumption of the households is an injection to the circular flow of income. However, in the case of Britain the increase in the consumption over the past years has not been that significant and so it has not helped to retrieve the income that is lost due to the leakage for which taxes are responsible. The savings as mentioned above reduced significantly in the last five years, because of the increased inflation and personal taxes, however the investments fell too. Saving is directly linked to investments in an economy. Although the reduction of the saving is good for the circular flow of income and money as it is a leakage in the flow, however lesser savings mean lesser investments. As a consequence, the investment that proves to be an injection in the flow also decreases. The same has been observed in the case of Britain in the last five years. The firms in the British economy have also suffered. Although the production that was recorded in the first quarter of 2010, as Macnamara (2010) states, was higher than the highest recorded in 2006. The output production increased in the United Kingdom by 0.7%, in the first three months of 2010. Since the firms provide goods and services that are purchased by the household in the circular flow of income, the increase of the production may have better results on the economy. However as Duncan (2008) argues, the increase in the production has not been very significant and so the economic growth has not been favored lately. Another important trend that has been observed in the economy of the United Kingdom in the past few years, as Duncan (2008) discusses, is the reduction in the exports. One of the reasons of this trend would be the increased inflation in the country. Because of increased inflation, the exports of a country become less competitive in the world market. As a result, the demand for these exports decrease. (People substitute the good for others that are low-priced). The same has happened for the United Kingdom lately. The exports have decreased and the imports have increased. (People substitute the local goods for the foreign ones because of the higher prices). Since the imports are a leakage to the flow of income and the exports are an injection, the flow of income in the economy has decreased. Overall, the increases in the imports and taxes have adversely affected the circular flow of income in the United Kingdom. The reduction in the investment and the exports has reduced the injections to the flow. Therefore, in the past years the flow of income in Britain has been adversely affected in the last five years. Now the paper discusses the economic performance of Germany in the last five years. Germany’s Macroeconomic Performance According to Theising (2007), the output production in Germany in 2007 fell the most in seven years. Over the next few years the output production has increased to some extent but the change in the output production for the last five years overall is not that good. Since the overall production is not increasing, the firms and the business institutions are not performing well. A reduction of the products and services mean a reduction in the flow of goods and services from the firms to the households. Furthermore, the exports for Germany have risen considerably. The exports in 2008 were recorded to have increased by 7.2% to EUR 145.6 billion. As far as the circular flow of income in the economy is concerned, the exports prove to be an injection in the economy so the flow is improved. However, at the same time the imports of Germany have also increased. The percentage by which the imports grew in 2008 was 6.9%. However the total money that was lost to the imports was fairly less than the money gained through the exports. This means that the leakage caused due to increased imports has been fairly less than the injection to the flow by the increase in exports. The tit The inflation rates, according to Theising (2007), have not changed much in the last few years. Recently, the inflation rate has actually fallen. A fall in the inflation means that the consumption levels of the households have increased in Germany (since the people feel richer). However the savings of the people have also increased. Savings may prove to be a leakage to the circular flow of income in the economy, but increased savings also mean increased investments which act as injections to the flow of income. Therefore the leakage to the flow is greatly removed. Overall, the German economy has prospered in the last few years because of an increase of the flow of money in the economy, the main reasons for which are increased exports, consumption levels and investments. Conclusion To conclude, the flow of income in Britain is fairly less than the flow of income in Germany according to the circular flow diagram of income. The increase in the taxes and the imports of Britain has had adverse affects on the flow of income in the country. Also, the increases in the consumption levels and the reduction in the savings have had little to help the British economy. On the other hand, the exports for Germany have increased more than the imports thereby the flow of income in to the country has increased. References Amosweb. (2010). Circular Flow. [Internet] Available from http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=circular+flow [Accessed 24 April 2010] Duncan, G. (2008).UK economic growth weakest for three years. [Internet] Available from [Accessed 24 April 2010] Macnamara, K. (2010).UK economic growth is weaker than expected. [Internet] Available from [Accessed 24 April 2010] Pagoso, C. Dinio, R. & Villasis, G. (2008). The circular flow of economic activity. [Internet] Available from [Accessed 24 April 2010] Theising, G. (2007). German Industrial Production Fell Most in Seven Years.[Internet] Available from [Accessed 24 April 2010] Read More