Introduction

After you have worked through this learning unit, you should be able to use the circular flow model to illustrate and explain:

  • the three flows of production, income and spending
  • the interdependence between households and firms
  • the real and monetary (nominal) flows through the factor market and the goods market

Simple circular flow model with two participants and two markets

Concepts

Familiarise yourself with the following concepts before you start this unit:

Households – A household can be described as all people who live together and who make joint economic decisions or who are subjected to others who make such decisions for them. A household can consist of an individual, a family or any group of people who have a joint income and take decisions together. Every person in the economy belongs to a household.

Firms – A firm can be described as the unit that employs factors of production to produce goods and services that are sold on the goods market.

Factor market – It is the market in which the factors of production are sold and purchased.

Goods market – It is the market in which goods and services are sold and purchased.

Real flows – It is the flow of real things such as goods and services or the factors of production.

Nominal (monetary) flows – It is the flow of money in the form of money income (wages and salaries, interest, rent and profits) and spending on goods and services.

Read through the following extract (BusinesTech, 2017) on the technical recession in South Africa in 2017 and reflect on the questions that follow:

Technical recession in South Africa

The latest gross domestic product (GDP) data released by Stats SA shows that the South African economy declined by 0.7% in the first quarter of 2017, putting the country into a technical recession.

While the economy has slowed to a crawl over the past few years, the country has managed to escape the dreaded "official" recession tag.

In economic terms, a technical recession is described as two consecutive quarters of economic decline. The last quarter of 2016 showed a 0.3% decline; with the latest decline of 0.7% in the first quarter of 2017, South Africa fits the bill.

Source: https://businesstech.co.za/news/finance/177885/south-africas-economy-is-officially-in-recession/

If one takes a closer look at the different flows of production, income and expenditure what is clear is that during this recession the decline in production was mainly due to lower production levels in the manufacturing and trade sectors.  Associated with this decline in production is a decline in spending by households.  The decline in production and spending is also associated with a decline in income of households. It is this relationship between the flow of production, income and spending that we will investigate in more detail in this learning unit.

Questions for reflection

  • Why do you think the spending by households decline if the production in the economy declines?
  • What would your household do if the income of your household increases?
  • What would firms do if households decrease their spending on goods and services?