Economics

Combined Version Edwin G. Dolan Best Value Textbooks 4 th edition

Chapter 18 The Circular Flow of Income and Expenditure

• • • The Basic Circular Flow of Income and This figure shows the

circular flow of income and expenditure

economy.

for the simplest possible Production, carried out by firms, generates incomes for households in the form of wages, interest, rents, and profits.

Households immediately spend all of their income on consumption. Expenditure

Measures of Production:

GDP

 Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a specific time period, usually a year. 

Valued at Market Value



Only Final Goods and Services Count

: Sales at intermediate stages of production are not counted as their value is embodied within the final-user good. Their inclusion would result in double counting.

   Excludes financial transactions and income transfers these do not reflect production.

Must be produced within the geographic boundaries country.

Net additions to inventory also included.

since of the are current period output so are

4

Measuring Output as Income :

GDI

  

Gross Domestic Income: GDI is the sum of the income

(including profits)

received in producing final goods and services during the period. All of the payments made to producers are paid out to wage earners, business owners, governments, etc. Thus in total the incomes must equal to the payments, which are equal in dollar value to the total expenditures.

Payments include :

       

Wages and benefits paid to workers, Proprietors’ income, rents, interest, corporate profits, Indirect business taxes Net factor income from abroad Capital consumption allowance.

Definitions:

• Consumption : Purchases by households for their own use.

• Closed Economy : An economy with no links of trade or finance with the rest of the world.

Definitions:

• • • Tax Revenue : Total value of all taxes collected by government Net Taxes : Tax Revenue minus transfer payments Transfer Payments : Payments by government to individuals NOT as payment for a current period product or service.

– SSI, Pensions, unemployment, disability payments, etc.

Leakages and Injections in a

Closed

Economy • • • A

closed economy

is one that has no links to the rest of the world

Leakages

: Uses of income other than consumption –

Net taxes

(tax revenue minus transfer payments) –

Saving Injections

: Expenditures on GDP other than consumption –

Government purchases

of goods and services –

Investment

Leakages and Injections in a

Closed

Economy • Total leakages must equal total injections

(S+T=I+G)

• If the government budget has a

deficit

, it must borrow from financial markets • If the government budget has a

surplus

previous debt , the excess tax revenue is used to repay

An

Open

Economy • • • An

open economy

is one with links to the rest of the world One link is a new leakage, in the form of payments made by domestic residents for

imports

from the rest of the world • A second link is a new injection, payments made by foreign residents for

exports

from the domestic economy Total leakages must equal total injections

T+S+Im=G+I+Ex

Financial Outflows • If exports exceed imports, the excess earnings from sales of exports will result in

financial outflows

to the rest of the world • These can take the form of lending to foreign borrowers, or purchases of foreign assets by domestic investors

Financial inflows

• If imports exceed exports, the excess imports must be financed by –

financial inflows

from the rest of the world Borrowing from foreign banks or other sources – Purchases of domestic assets by foreign investors • The financial inflows can be used to finance a government budget deficit, for foreign investment in the private sector, or a combination of the two

• • • •

The Twin Deficit Syndrome (1)

Total injections must equal total leakages: (G-T)+(I-S)+(Ex-Im)=0 G-T is the government deficit (positive if deficit) I-S is the difference between investment and saving (positive if investment exceeds saving) Ex-Im is the “trade deficit” (net exports), positive when there is a trade surplus, negative when there is a deficit. When there is a trade deficit, there must also be a financial inflow

• • •

The Twin Deficit Syndrome (2)

Early 1990s:

Domestic saving sufficient to cover domestic investment plus part of the budget deficit, so trade deficit was moderate

Late 1990s:

Budget surplus helped partially finance growing investment, so trade deficit remained moderate

Mid 2000s:

Large trade deficit needed to finance growing investment and large government deficit

Components of GDP

• The sum of all expenditures on domestic goods and services (consumption plus all injections) must equal GDP • The basic equation for GDP:

Q = C + I + G + X N

( GDP = C + I +G + X

N

)

• We avoid double counting/ inappropriate counting by subtracting imports from total measured expenditures; so

X N = Exports - Imports

GDP = C + I +G + X

N

• • • • C = Consumption (household spending) I = Gross Private Domestic Investment • Fixed Investment (real Capital Purchases) • Inventory Investment (changes in inventory of finished products, intermediate products, or raw materials) G = Government Purchases • excludes transfer payments X N = Net Exports (Exports – Imports)

Planned Expenditure (

E

p

)

• •

Planned investment

components: (I p ) consists of two

fixed investment investment

+

unplanned inventory

Total planned expenditure is given by the following equation:

E p = C + I p + G + X N

Determinants of Consumption

• • • Consumption depends, in the first place, on

disposable income

The amount of added income devoted to consumption is called the

marginal propensity to consume

Consumption that takes place regardless of the level of income is called

autonomous consumption

• • • •

Other factors affecting consumption:

Consumer wealth The level of net taxes Interest rates Consumer confidence

Determinants of other expenditures

• • •

Planned investment

expenditure depends on

Interest rates Business confidence Other elements of the business climate in the domestic economy and abroad • •

Government purchases

considered to be autonomous, that is, determined by political factors outside the economic model are

Net exports

depend on – – – The level of domestic income Exchange rates Level of foreign income

Equilibrium in the Circular Flow

• • The circular flow is said to be in

equilibrium

when total planned expenditures equal GDP In that case, there will be no unplanned inventory investment • • If there is unplanned inventory

decrease

, firms respond by increasing output and the circular flow

expands

If there is unplanned inventory

increase

, firms respond by reducing output and the circular flow

contracts

Injections

•

For equilibrium to occur, leakages must be offset by corresponding

injections

.

•

Injections include

investment, government spending, and exports

.

Leakages and Injections

Spending Multiplier

• The spending multiplier is a measure of the change in equilibrium income (real GDP) produced by change in autonomous expenditures determined independent from income levels/GDP) (Spending that is – By how many dollars does real GDP change for every dollar change in autonomous expenditures?

Multiplier  1 leakages 

MPS

1 

MPI

• • MPS: marginal propensity to save MPI: marginal propensity to import

Marginal Propensities

• • • Marginal Propensity to Consume (

MPC

) Marginal Propensity to Save (

MPS

) Marginal Propensity to Import (

MPI

) – Each of these is stated in a decimal as a share of 1.

(They are considered as a percentage of disposable income generally assigned to each of category of income disposition) – For Example: MPS =0.2 means that 20% of disposable income is saved in this economy .

Computing the Spending Multiplier

Multiplier  1 leakages 

MPS

1 

MPI

If

MPS

= 0.30 and

MPS MPI

+

MPI

is 0.10, then = 0.40 = 4/10.

1/0.40 = 1/(4/10) = 10/4 = 2.5

The multiplier is 2.5.

NOTE: The spending multiplier would be larger in a closed economy because MPI would be zero.

Multiplier at Work

Gaps

GDP Gap

•

GDP gap

= potential real GDP – actual real GDP

Recessionary Gap

Recessionary gap

– How much additional spending must occur to achieve potential GDP (i.e., to create full employment)?

Recessiona ry gap  GDP spending gap multiplier