The Circular Flow,

Savings & Investment and

Long Run Model
 Circular Flow
Our simplified economy consists of:
Three Groups of Economic Actors
Households: Provide labor, earn Income, buy consumption, pay taxes and save.
Firms: Hire labor, raise capital, produce and sell output, maximize profits
Government: Raises taxes, buy goods & services, borrow.
Three Groups of Markets
Market for Goods & Services: Firms sell to households and government
Market for Factors of Production: Households provide labor to firms
Financial Markets: Savings of Households are channeled to firms and
government

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The Circular Flow
Consumption, C
Firm Revenue, Y Markets for
Goods & Services
Investment, I

Govt Financial
Purchases, Markets
G Public
Saving Private
Firms Saving, S

Government Taxes,
Households
T

Markets for
Factors of Prodn
Wages, Interest, Rent, & Profit Income, Y

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Production of Goods & Services
Factors of Production
Inputs into production: Capital, K and Labor, L
At any point in time these factors are fixed in quantity: K0 and L0
Assume factors fully utilized, no wasted (unemployed) resources.
Together these characterize a Static version of the economy in Long Run
equilibrium.
These results are termed full employment or potential GDP, etc.

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 Production of Goods & Services
Aggregate Production Function for all Firms
Prodn technology shows Output (Y) for inputs of capital and labor,
Y = F(K, L)
Assume Constant Returns to Scale
zY = F(zK, zL) for any constant z.
Supply of Goods & Services by firms
At any point in time in Long Run equilibrium output is fixed by the level
of the existing factors of production and technology.
Y = F(K0 , L0 ) = Y0
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