Question

Use the circular-flow diagram to explain how an increase in the amount of money spent by households results in an increase in the number of jobs in the economy. Describe in words what the circular-flow diagram predicts.

Short answer

The increase in the amount of money spent by households in the economy will increase the demand for goods and services. The firms will increase the supply to meet the demand by employing more workers. The number of jobs in the economy will increase.

Step-by-step solution

Circular flow diagram

A simple economy has two kinds of markets. There are markets for goods and services (shown on the left side in the diagram below) where households buy the goods and services they want from firms. There are factor markets (shown on the right side in the diagram below) in which firms buy the resources they need to produce goods and services.

The simplest circular-flow diagram is shown below:

When the amount of money spent by households increases

Firms sell goods and services they produce to households in the markets for goods and services. On the other hand, the firms buy the resources from households in factor markets to produce the goods and services.

The households purchase goods and services from firms in the markets for goods and services that generate a flow of money to the firms and a flow of goods and services to the households. As the firms purchase factors of production from the households in the factor markets, the money flows back to households.

Thus, an increase in the amount of money spent by households results in the increase in demand for goods and services. This will result in the firms employing more workers for production. The number of jobs in the economy will therefore increase.