Circular Flow of Income/PPP/FDI Notes

1 The Circular Flow of Income Fig 1: 4-Sector Circular flow of Income Step 1: Explain Injections and Withdrawals to set up key terms In a 4-sector economy, injections are additions of spending to the circular flow of income which increase the income-spending stream, consisting of investment expenditure (I), government expenditure (G) and export revenue (X). On the other hand, withdrawals are a leakage of potential spending from the circular flow of income which contracts the income-expenditure stream., consisting of savings (S), taxes (T) and import expenditure (M). Step 2: Explain the Circular Flow of Income Fig 1 shows that when firms produce goods and services, they hire factors of production — labour, land, capital, and enterprise — from households, and pay respective factor payments for them — wages, rent, interest, and profits. Households in turn spend their factor income on the consumption of goods and services. Households may also decide to save part of their income in the financial market as savings (S), which in turn loans out funds to firms to make productive investments. In addition, households also pay taxes (T) to the government, which spends the tax revenue on, for example, provision of public goods and merit goods. Simultaneously, incomes are injected into the circular flow from the foreign sector via exports (X) and incomes are withdrawn into the foreign sector and thus leak out of the circular flow via imports (M).

Step 3: Explain Disequilibrium and Equilibrium How much firms invest may differ from how much households save, how much governments spend may differ from what they receive in taxes, and export revenue can exceed import expenditure or vice versa. Thus, planned injections may not equal planned withdrawals. A net withdrawal contracts the income-expenditure stream, reducing national income while a net injection increases the level of income. When net injections are not equal to net withdrawals, the circular flow of income is in disequilibrium and fluctuations in the level of economic activities will arise. The economy will be at equilibrium when the total injections equal the total withdrawals. 2 Purchasing Power Parity Let’s estimate that a Big Mac costs 6 SGD in Singapore, and 20 MR in Malaysia. Clearly, the same goods and services may cost different amounts of currency in different countrie