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The Circular Flow of Income Five-sector Model (Y)
(C)
s e g a k a e L
(S )
(I)
(T)
(G )
(M)
s n o i t c e j n I
(X)
This can also be represented as a equation: Y=O=E=C+I+G+X-M Where: Y = Total income O = Total output (GDP) E = Total expenditure (Used in Australia to calculate GDP) C = Consumption expenditure I = Investment expenditure G = Government expenditure X = Expenditure on exports M = Expenditure on imports Concepts
Circular Flow Model Model of the economy, based on income flows from one sector of the economy to another in a circular motion, which explains levels of national income and output and how changes in these occur. Equilibrium Balances situation from which there is no tendency to change, for example the level of output or income brought about by conditions in an economy.
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Expenditure Outflows of money from one sector of an economy to another. Income Inflows of money to one sector of an economy from another. Injections Inflow of income into the circular flow of income. Leakage Outflow of expenditure from the circular flow of income. Output Production of goods and services in an economy from combining land, labour, capital and enterprise. Methods of Measuring Total Production
• Production Method • Income-received Method • Expenditure method (said to be most accurate) Equilibrium in the Circular Flow
businesses) the economy would always be • In the two sector model (households and businesses) in equilibrium. • If we add the financial sector, some money leaks out out and some is injected. To have equilibrium savings have to equal investment [S=I]. S+T+M=I+G+X • I a five sector model, to achieve equilibrium we require S+T+M=I+G+X • Changes in any one of the variables will bring changes in the total deistic production and income. • The level of production will change of the equilibrium is changed. Business and Trade Cycle
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Economic Objectives and Macro-Economic Performance
• Economic growth (sustainable) • Price stability • Full employment • External balance • High standard of living Usefulness of the Circular Folw
• Enables us to gain a simplified picture of the Australian economy
Income and expenditure Analysis Keynesianism
• Economic theory based on the ideas of John Maynard Keynes • Analyzing and understanding the macro-economic forces that determine aggregated production, income and employment and providing ways of managing economic activity during a recession or depression through demand management. • Link between income, expenditure, production (Y = O = E) • The predicted level of GDP is the equilibrium level, which could be expressed by the equation Y = C + I + G + X - M • Not about how people earn but how they spend their income • If all income is getting Spent then the economy is in equilibrium, but is not nessarily performing at its full employment potential • Aggregate Demand (E) = C + I + G + X -M • Changes in Aggregate Demand will result from changes in various expenditure flows. • Aggregate - Whole economy
Consumption
• Can consume more than they earn/produce • Break even - where all income is spent on consuptipon • Produce more than you need to consume (wealth) Economy where Aggregate Demand > level of production production to rise income When Aggregate Demand < Output • Profits fall • Stocks of unsold goods rise
stimulate level of
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• Decrease in production • Increase in unemployment Consumption Function
C=a+bY Where: a = Autonomous Consumption b = Marginal Propensity to consume Y = Income C = Consumption b Y = The propensity of EACH dollar consumed as income increases • The lower your income the higher your marginal propensity to consume MPC - Marginal Propensity to Consume MPS - Marginal Propensity to Save
The ratio of each extra $ earned being consumed/save. As extra disposable income can only be spent or saved the Marginal Propensity to Consume and Marginal Propensity to Save will always always = 1. Consumption = Autonomous Consumption + Marginal Propensity to Consume • Individual’s spending habits don’t (generally) affect earning capacity • Spending by the whole economy causes it to expand / contract towards level of income where all elements of production are sold Spending Shows level of Aggregate Demand ↓
Level of Production (O) ↓
Demand for recourses ↓
Income Autonomous Consumption - Spending that is required
- Survival level of consumption • How much we spend depends on income • If income is high smaller proportion of income spend on consumption • But if income goes low enough, consumption > income
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Propensity to Consume (proportion (proportion of income spent on consumption) consumption) APC - Average Propensity APC = C / Y • As income increases so will Average Propensity to Consume Income / Consumption & Savings Schedule 22,000 45º Line
20,000
Saving Schedule
18,000
B r e a k E v e n
Consumption Schedule
16,000 14,000 ) $ ( e r u t i d n e p x E
12,000 10,000
m d u i a n r m e b i e D e l t a u e g q g r e g E A
8000 6000
Consumption
4000 Investment
2000
Saving 0
0
4000
8000
12,000
-2000 Income ($)
Savings
• Savings is the difference between income and consumption S=Y-C We know that C = a + bY S = -a + (1 - bY) S = -a + Marginal Propensity to Save * Y
16,000
20,000
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Marginal Propensity to Save (MPS) - Proportion of any increase in income that is
saved. MPS = ∆S / ∆Y MPC + MPS = 1 Average Propensity to Save - The total proportion of income saved (APS = S /Y) and
the Average Propensity to Consume also equal 1. Average Propensity to Save = Savings / Income Average Propensity to Consume + Average Propensity to Save = 1 Why do we Save
• • • • • •
Planned and unforeseen expenditure Security Expensive purchase Compulsory saving for the future Take advantage of capital gains/ good interest rates Love of money
• Occurs when income not spent on consumption (S = Y- C) • Combined savings of households, businesses and government is known as national savings Effect on Economic Activity / Performance
• Veery Significant • Savings recycled through capital and financial markets to fund investment. The more we save the lower the interest rate. More Savings
Less Borrowing
Less Foreign debt and lower costs associated with debt servicing
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This is the Paradox of Thrift
If people plan to save more the economy will deflate and people may be forced to save less. Investment (I)
• Investment represents expenditure on (or production of) new plant and equipment (capital) in a given period, plus changes in business inventories. It is affected by two main factors: interest rates and expectations. Thus if interest rates where high and/or we were entering a contractionary phase in the business cycle, investment would almost certainly drop.
Equilibrium (Ye)
model, equilibrium is attained attained where aggregate aggregate output or income is • In the Keynesian model, equal to aggregate expenditure injections point of view view to achieve equilibrium, leakages leakages must equal • From leakages & injections injections that is Savings + Taxes Taxes + Imports = Investment Investment + Government Expenditure + Exports or in the three sector model Savings = Investment • The equilibrium level of national income - is a term used by keynes to describe a level of national income at which the economy will move towards and settle at.
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• Keynes argued that equilibrium would be the national income at which Aggregate Demand = Aggregate Supply Equilibrium = Aggregate Demand = Aggregate Supply Aggregate Supply = Output (income) Income = Consumption + Savings Aggregate Supply = Consumption + Savings Aggregate Demand + Consumption + Income Equilibrium = Consumption + Savings = Consumption + Income Or Savings = income (planned savings = planned investment) Economy’s operating at equilibrium have 2 characteristics
• Aggregate Demand = Aggregate Supply • The total expenditure is equal to the value of production of all firms in the economy. • A equilibrium economy plans to save so that savings just equal plans to invest Finding Equilibrium
Equilibrium = Autonomous Autonomous Consumption Consumption + Investment / Marginal Marginal Propensity to Save Save Or Equilibrium = Consumption + Income • Equilibrium will also be represented where savings is equal to investment on the graph disequlibrium • If an economy is not in equilibrium it is disequlibrium The Multiplier (k)
• Is how much equilibrium is increased by an increase in spending • Called income multiplier or just the multiplier Multiplier = 1/Marginal Propensity to Save Or 1/ 1 - Marginal Propensity to Consume • This formula suggests that the size of the marginal propensity to consume, controls the impact of a change in Investment • The lower the marginal propensity to consume the less powerful the income multiplier • The higher the leakages the less powerful the income
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• Investment change has a magnifying effect • Every time the multiplier increases there is a smaller increase in consumption Importance of the Multiplier
• This multiplier concept is important to the Government in the management of economic activity. • The multiplier can also work in reverse, due to a fall in autonomous expenditure or investment. In most cases the Government would prefer income, demand and production to rise.
Inflationary and Deflationary Gaps Deflationary Gaps (Economy Doing Poorly)
• Equilibrium is at a level far below the income and output needed to make full use of the nation’s factors of production. Keynes called this a Deflationary Gap. • The solution to the deflationary gap - Governments should deliberately plan to run large budget deficits by increasing increasing government spending or cutting taxes . This This would allow Aggregate Demand to rise by the size of the deflationary gap. Inflationary Gap (Economy Doing Good)
• Equilibrium could be above the income and output needed to make full use of the nation’s factors of production. Keynes called this an Inflationary Gap • An Inflationary gap occurs when aggregate demand is so strong that Ye occurs at levels beyond the output capacity of the economy. • Inflation occurs because once the economy’s output reaches Ye and continues to the right, the quantity of production cannot change and so factor price rises are the only means firms can use to attract already employed resources away from other firms. Full Employment
When everyone who wishes to work is employed Inflation
Is the general increase of prices and subsequent fall in purchasing power of money. Fiscal Policy
A government policy for dealing with the budget (especially with taxation and borrowing). Monetary Policy
The regulation of the money supply and interest rates by a central bank, in order to control inflation and stabilise currency
