circular flow model

1Unit6:CircularFlowModel6.1SimpleModel6.2Keynesian2sectormodel6.3Keynesian3sectormodel6.4Keynesian4sectormodel26.1SimpleModelA.SourcesofIncomeB.MoneyIncomeC.DisposableIncomeD.RealIncomeE.TheCircularFlowofIncome3A:SourcesofIncomeDefinition:IncomeisthemoneyearnedfromtheemploymentofresourcesSourceofIncome(Resource)TypeofIncomeLandRentCapital/EnterpriseProfitLabourWagesFinancialCapitalInterest4IncomeB.MoneyIncome=IncomereceivedfromallsourcesC.DisposableIncome=IncomeafterdeductingtaxD.RealIncome=Moneyincomeadjustedforinflation.Itrepresentsthepurchasingpowerofmoneyincome5E.TheCircularFlowofIncomeTheCircularFlowModelisusedinmacroeconomicstoanalysetheoverallbehaviouroftheeconomybyobservingaggregatelevelsof:–Income–Output(production)–Employment,and–ExpenditureAndthererespectivefluctuations6SimpleModel(SGp.33Diagram)Assumptions1.Only2Unitsintheeconomy•HouseholdsandBusinesses2.Allbusinessproductionissoldtohouseholds3.Allgoodsarefinal(nointermediategoods)4.Nofinancialsector–(nosavingorinvestment).HouseholdsspendALLtheirincome5.NoGovernmentsector–NoTaxes6.NoOverseassector–Noimports&exports74Flows1.SupplyofresourcesfromHouseholdstobusinesses2.PaymentofIncomesfrombusinessestohouseholdsfortheuseofresources3.Supplyofgoodsandservicesfrombusinessestohouseholds4.Consumptionexpenditurepaidfromhouseholdstobusinessesforgoodsandservices8Product&FactorMarkets9ProductandfactormarketsFactorMarket•Arethemarketsforthedifferentfactorsofproduction(resources)i.e.whereresourcesareboughtandsolde.g.•labourmarket–themarketforhumanresources,i.e.workers•Naturalresourcesmarket–e.g.ironoreProductmarket•Arethemarketsforfinalgoodsandservices•Buyers:Consumersoffinalproducts•Sellers:Suppliersoffinalproducts10Theequalityofincome&expenditure•$1worthofoutputrequires$1worthofresources.•Toprovide$1worthofresourceshouseholdsarepaid$1inincome.•The$1ofincomeisthenspentonconsumingthe$1worthofoutputproduced.Total=Total=TotalIncomeOutputExpenditureIncome(Y)=ConsumptionExpenditure(C)11Theequalityofincome&expenditure•Theexpenditureofbusinessesbecomestheincomeofhouseholds.•Thelevelofresourcesemployedisdependentonthelevelofspending.•Itistheleveloftotalexpenditureintheeconomythatdeterminesthecorrespondinglevelsofincome,outputandemploymentfortheeconomyasawhole12Theequalityofincome&expenditure•Sinceallincomeisspentbyhouseholdsonthefinaloutputproducedbyfirms,theflowofincomeshouldcontinueindefinitelysincenothingisbeinginjectedorwithdrawnfromthesystem.•Thecircularflowissaidtobeinequilibriumwhentheeconomycontinuestoflowatthesamelevelofincome,outputandemployment.136.1Questions1.Whatarethemainassumptionsofthesimplecircularflowmodel?2.Distinguishbetweenthefactormarketandtheproductmarketinthesimplemodel.Drawadiagram.3.Explainwhyincome,outputandexpenditureareequalatequilibriuminthesimplemodel.146.2Keynesian2sectormodelGoods&ServicesIncome(Y)Consumption(C)Savings(S)Investment(I)HouseholdsBusinessesFinancialsector15TheFinancialSector•ByintroducingtheFinancialSectortothemodelweintroduceSavings(S)andInvestment(I)SAVINGS•Savingsisthatpartofhouseholddisposableincomenotspentoncurrentconsumption•Savingsissaidtobealeakage(orwithdrawal)fromtheflowofincome.16Investment•Investmentistheprivatetotalexpenditureoncapitalgoods(suchasmachinery,plantandequipment)andchangesininventories.•Investmentisexpenditurenotforcurrentconsumptionbutfortheexpansionofproductivecapacity.•Investmentisaninjectionintotheflowofincome.TheFinancialSector17AggregateExpenditure(AE):2sectorModel•AggregateExpenditure(AE)isthetotalamountofspendingongoodsandservices.•Inthe2sectormodelthereare2componentsofAE:–PrivateConsumption(C),and–PrivateInvestment(I)AE=C+I18EffectofSavings&InvestmentIfS=I–thentheeconomywillbeinequilibrium.Income,outputandemploymentwillremainunchanged.IfSI(anetleakageofsavings)–Therewillbeabuildupofstocks.Firmswillrespondbyreducingemploymentofresourcesandproduction.–Thelevelofincomewillfallastheeconomybeginstocontracttoalowerequilibriumlevel19EffectofSavings&InvestmentIfIS(anetinjectionofInvestment)•Stocklevelswillfallduetotheexcessdemandabovecurrentproduction.Firmswillrespondbyemployingmoreresourcesandincreasingoutput.•Thelevelofincomewillriseastheeconomybeginstoexpandandeventuallyreachesanewhigherequilibriumlevel.20Consumption&itsdeterminantsConsumption:•Spendingbyhouseholdsonconsumergoodsandservices.•ItisaverystablecomponentofAE.•ItisthelargestcomponentofAE–itrepresentsabout60%ofAE.•Itincludesexpenditureonnon-durableanddurableconsumeritems.•Itonlyincludesexpenditureonfinalgoods&services.21Consumption&itsdeterminantsThefactorsthataffectConsumptioninclude:a)Householddisposableincomeb)Costandavailabilityoffinancec)Consumerconfidenced)GovernmentActione)Distributionofincome22InvestmentanditsdeterminantsInvestment•Investmentistheprivatetotalexpenditureoncapitalgoods(suchasmachinery,plantandequipment)andchangesininventories.•Itisaveryvolatile(unstable)componentofAE.•Itaverages12%-15%ofAE23InvestmentanditsdeterminantsThefactorsthataffectInvestmentinclude:a)Businessconfidenceb)Costandavailabilityoffinancec)