Circular Flow of Income and the Business Cycle

Title: Circular Flow of Income and the Business Cycle
Subject: Economics
Type of Paper: Assignment

1.0 Introduction
The IMF (1996, p.4) defines an economy as: “an economic entity having a center of economic
interest within a specific territory.” To explain them, hypotheses, theories and laws can be used.
To understand them they can be conceptualised (and simplified) in various ways, for example
through models, systems and networks, through institutions and/or through an evolutionary
Aim: This paper looks at some aspects of explanation (how we understand the economy):
hypothesis – theory and law building, conceptualisation, systems and model building, with the
examples of the circular flow of income and the business cycle.
1.1: Constructing a narrative: A narrative is a ‘story’, in this case a story about the world
economy. Who starts the story and who re-enforces it are interesting questions (the role of global
media). Once a narrative become established it becomes difficult to dislodge, even where the
evidence appears to contradict it. The challenge is to be constantly critical of prevailing
narratives and to be prepared to switch to a new narrative where the evidence no longer supports
the existing one. As Mark Twain said: “It isn’t what you don’t know that gets you into trouble.
It’s what you know for sure that just isn’t so.” (Samuel Langhorne Clemens 1835-1910).
1.2: Conceptualisation: Just as a narrative builds a story about the world economy, so
conceptualisation involves the way in which we think about things, the mental pictures we have.
Narratives, and the conceptualisations associated with them, define the questions we ask about
the world economy and our interpretation of it. One test of the value of our conceptualisation is
whether or not they lead us to ask questions the answers to which help resolve problems in the
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1.3: Hypothesis, theory and law: The practice of scientific investigation and explanation is
normally to start with a hypothesis. This is a statement about what you think may be a
relationship in the economy. For example: “countries with large public debts grow more slowly
than those with low public debts.” The next step is to gather evidence to see whether or not this
relationship is correct. If extensive study found this relationship to hold, then it would be
possible to state the relationship as a theory: “Countries with high public debt grow more slowly
than countries with low public debt”. Then, if over a long period of time and more evidence that
consistently showed this relation to hold, the theory could be restated as a law. In practice, in
business studies there are few, if any, laws. Most theories only tend to be reliable for a limited
period under certain conditions.
1.4 Models, systems and networks
Models: A model can be defined as a simplified representation of reality. Models include what
are considered to be the most important elements of reality in relation to the purpose for which
the model is designed. Model building is part of scientific method, which can be described as: i)
observation and description; ii) classification; iii) identification of a problem (derived from a
paradigm: or set of theories within which certain questions are posed); iv) formulation of
hypotheses: assertions about the relationship between events; a set of testable statements; v)
development of theories (from hypothesis testing) and laws.
Systems: A second type of conceptualisation is a system (see Wallerstein 1979). This category of
model emphasises interaction. A system is "a set of objects together with the relationships
between the objects and their attributes" (Hall and Fagen, 1956; p.18). The objects in the
economic system include all those activities and institutions that perform a role in the operation
of the economy: offices, factories, farms, trade unions, multinationals etc; or spatially they may
embrace areas demarcated as supranational (trade blocs), national, regional or local (urban subsystems). Each object itself contains a sub-system (nested systems) and thus the definition of
objects in a system depends on the resolution level of the analysis. The relationships between the
objects are the links that tie the system together: flows of goods, people, money and information.
It is also important to understand the ‘rules’ governing the relationships. Conceptualising the
world economy as a system can be particularly useful if the objective is to assess the impact of
change in one part of the system (world economy) on other parts. However, the world economy 
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is a system of human interaction, and is thus different to a physical system. A simple example of
an economic system is illustrated by the ‘circular flow of income’. This shows some of the key
relationships in an economy.
[Note: Models and systems should be evaluated on whether they make justifiable assumptions
and provide useful insights. In a relational and dynamic world economy simple models will
always be open to criticism.]
An economy can be conceptualised as a system, which itself comprises a set of structurally and
geographically nested open sub-systems, which interact across their boundaries with each other
and across the economic system boundary with social, political and environmental systems.
Local economies can also be thought of as comprising different ecosystems, for example one
area may be characterised by the automobile industry, in this automobile ecosystem top tier car
assemblers may be supported by lower tier component suppliers. Through time the world
economy may become either more integrated (based on free trade) or more fragmented into subsystems (segmented or compartmentalised).
Interdependence (feedbacks) within the global economic system: A central characteristic of a
system is the linkage and interdependence between its parts. Change in one part of the system
will have repercussions elsewhere. The impact of a change depends on the nature of the linkages
between sub-systems and the positive or negative feedback loops created by the change (resulting
in deviation amplification or deviation reduction). Examples include: oil price rises following
hurricane Katrina in the United States in August 2005; the repercussions of the destruction of the
twin-towers in New York on 11 September 2001, and the fall-out from the US sub-prime lending
crisis beginning in 2007.
Interconnection across system boundaries: There are also interconnections across the boundaries
of economic systems to political, social and environmental systems. These interact and thus in
looking at how the world economy operates the interactions with other types of systems cannot
be ignored. In geopolitical terms, when the Berlin Wall was dismantled in 1989 and the Soviet
Union began to be broken-up, and when China began to embrace capitalism, the old bi-polar
Cold War struggle slipped into history. The fear of Armageddon associated with a nuclear war
was eased. But in its place has come a much more diffuse set of threats, particularly those
centred on ideologies and terrorism, drug trafficking and financial fraud. Local conflicts exist
around the world, debilitating economies in Africa and South America and threatening the 
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stability of the world economy. In addition, new types of threat are emerging involving
information and communications technologies that span activities from international financial
fraud to computer viruses. Finally, there are environmental threats. These include diseases and
global epidemics such as ‘bird flu’ HIV aids and malaria. Global climate change could radically
change the environment, with for example changes to sea level that could flood coastal areas
around the world, the places where the majority of the world’s population live. The melting of
ice-caps in the Himalayas could radically change the availability of water throughout South East
Asia. Many major economic centres (for example San Francisco and Tokyo) are located on faults
in the earth surface and thus face disruption from earthquakes. These and many more events are
ever present threats to the world economy.
1.5 Adopting a network perspective views the global system as structured into complex and
constantly changing networks of flows (Castells 2000): corporate networks (as for example
represented by transaction patterns, supply chains and business alliances), political networks,
urban networks and knowledge networks. Accessing high quality networks creates competitive
advantage for both businesses and places. World cities are major nodes in these networks of
The global economy is depicted as incorporating “the complex actions and interactions of a
variety of institutions and interest groups – economic, political, social, cultural – which operate
at multi-scalar levels and territorialities and through dynamic and asymmetrical power
relationships to produce specific geographical outcomes: the material world in which people
struggle to make their lives.” (Coe et al 2008, 271). Production networks can be defined as: “... at
its core, the nexus of interconnected functions, operations and transactions through which a
specific product or service is produced, distributed and consumed.” (Coe et al 2008, 274).
1.6 From an institutional perspective the world economy is made up of actors and social
structures – institutions - intricately interconnected into a myriad of institutional networks at
many hierarchical (horizontal) levels, all vertically connected as parts of the global whole. The
nature of these institutions will play an important role in determining the evolution of economies
(Brousseau and Glachant 2008).
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1.7 An evolutionary perspective to economies: Another approach to thinking about the economy
(conceptualisation) is to view it through the prism of evolutionary theory (or Darwinism
generalised to the social sciences). Evolutionary theorists tend to be dissatisfied with static or
equilibrium-oriented theory that neglects technology and innovation. Theory emphasises the
complexity of social phenomena (see also complexity theory) and the unpredictability of many
processes. It emphasises complex population systems (populations of entities that are similar in
key respects, but within each type there is some degree of variation) where the core Darwinian
principles of variation, inheritance and selection apply (Hodgson 2009). As in the evolution of
species, the most competitive businesses survive while weaker businesses die out. Businesses
that gain ‘first mover advantage’ must work hard to stay ahead of competitors.
“Change is one of capitalism's constants. As a mode of economic organization, capitalism never
stands still. Its central imperative—the search for profit and wealth creation—drives a perpetual
process of economic flux. Every day new firms, new products, new technologies, new industries
and new jobs are added to the economy, whilst old firms, products, technologies, industries and
jobs disappear. Joseph Schumpeter once famously described this constant flux as a process of
‘creative destruction’ that ‘incessantly revolutionizes the economic structure from within,
incessantly destroying the old one, incessantly creating a new one’ ( 1942, 82). The economy, in
other words, evolves” (Boschma and Martin 2007, 537).
Evolutionary theorists underline the possibilities for path creation and path destruction and of
social agency as opposed to relentless path determinism. The development of an economy can
involve many branching points rather than fixed trajectory (Mackinnon et al 2009).
Thus the global economy can be conceptualised in a number of ways. Each can yield valuable
insights into how the economy works, each has its own merits and limitations, and each may be
more or less appropriate for understanding different aspects of the global economy. 
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? Boschma, R and Martin R. (2007) Constructing an evolutionary economic geography,
Journal of Economic Geography, Vol.7, 5, pp.537-48
? Brousseau, E and Glachant, J. eds. (2008) The new institutional economics. Cambridge:
? Castells, M. (second edn, 2000) The rise of the network society. Oxford: Blackwell.
? Coe, N, Dicken, P. and Hesse, M. (2008) Global production networks: realizing the
potential, Journal of Economic Geography 8, 271-95.
? Hall, A and Fagen, R (1956) Definition of system, General Systems 1, pp.18-28
? Hodgson, G. (2009) Agency, institutions, and Darwinism in evolutionary economic
geography, Economic Geography, 85 (2) 167-73
? Hodgson, G. and Knudsen, T. (2006) Why we need a Generalized Darwinism: and why a
Generalized Darwinism is not enough, Journal of Economic Behaviour and Organization
61, 1-19.
? IMF (1996) The balance of payments textbook. Washington.
? MacKinnon, D., Cumbers, A., Pike, A., Birch, K. and McMaster, R. (2009) Evolution in
economic geography: institutions, political economy and adaptation, Economic
Geography, 85 (12) 129-50.
? Schumpeter, J. (1942) Capitalism, socialism and democracy. New York: Harper
? Wallerstein, I (1979) The capitalist world economy. Cambridge: CUP. Chapters 1, 3 and
4. This author has written widely on the subject of the global economy, adopting a
sociological analysis.
Essential Reading
? Hill, C. and Hernández-Requejo, W. (7th global edn, 2011) Global business today.
McGraw-Hill. Part Two, Chapters 2 and 3 

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