After you have worked through this section of the learning unit, you should be able to:
- identify the three major flows in the economy and describe the relationship between them
The three major flows in the economy are:
- The production flow comprises the production of goods and services by firms. It is here that the question of how to produce is answered.
- The income flow involves the flow of income to households which they earn from making the factors of production available for the production of goods and services by firms. Based on this income, the question of for whom to produce is answered.
- The spending or expenditure flow entails the spending by households on goods and services produced by the firms. It is during this flow that the question of what to produce is answered.
Thinking about these flows choose the correct option in the following question:
Do you think a person who is employed by a factory that produces mattresses is part of the flow of production, income and spending?
While the person is working in the factory producing mattresses, he or she is part of the production flow. When the person is paid, he or she is part of the income flow, and when he or she spends this income, he or she is part of the spending flow. The person is therefore part of all three flows.
The flows are not independent, but interdependent and closely linked. This interdependence between production, income and spending can be represented by the following circular flow diagram:
Three major flows
A change in the flow of production will bring about a change in the flow of income which, in turn, will change the flow of expenditure, which again will change the flow of production.
In the same way, an increase in spending will bring about an increase in production which, in turn, causes an increase in income. Similarly, an increase in income will bring about an increase in spending and then production. A major part of the study of macroeconomics is about how changes can be brought about in these flows.
Link between production and income
Link between production and income
The reason we produce goods and services is to satisfy our needs and wants. To produce these goods and services, factors of production are needed.
In a market system, the factors of production belong to households, who are then paid an income by producers for the use of the factors of production. As production takes place, a flow of income is created. If you are working (employed), the contribution of your effort is part of the production flow, while the payment you receive is part of the flow of income.
Link between income and spending
Link between income and spending
We have now established that as production takes place, a flow of income is created. This income, which flows to households from firms, is then spent by the households on the goods and services that were produced, and as they spend, a flow of spending or expenditure is created. As you spend the income you received from taking part in the process of production, you are creating a spending flow.
Link between spending and production
Link between spending and production
The spending in the economy is linked to production. When we bake bread, we are taking part in production, when we are paid for baking the bread, we are
part of the income flow, and when we spend our income on buying the bread, we are part of the spending flow.
Example of the interdependence
James is a family man and works at the local bakery as a bread baker. To illustrate the circular flow between production, income and expenditure, we are going to use part of James's life story.
As James works as a baker and bakes bread, he is part of the production process. At the end of every month, James receives a salary from the bakery for his bread making. The salary James receives is income for him and his family. James's wife Martha does the shopping for the household at the end of every month; she buys everything the family needs, including the bread James helped bake. James's family is now part of the spending or expenditure process. That will happen all the time as long as James works and spends his income.
There is thus a continuous circular flow between production, income and spending in the economy. A change in production, such as an increase in production, will lead to an increase in income, which, in turn, will result in an increase in spending.
Activity
Indicate whether you agree or disagree with the following statement:
The lower the level of production in a country, and the lower the level of income and spending, the poorer the country.
You should indeed agree.
Poor countries have low levels of production, income and spending, while rich countries have high levels of production, income and spending.
Think again. You should agree.
Poor countries have low levels of production, income and spending, while rich countries have high levels of production, income and spending.