CIRCULAR FLOW OF INCOME

The Circular Flow of Income

The Circular Flow of Income

The circular flow of incomeThe circular flow of income

The interdependence of goods markets

and factor markets

The interdependence of goods markets

and factor markets

The circular flow of income: a simple economyThe circular flow of income: a simple economy

Assume that households spend all their income, no savings and no government

There are two types of transactions between households and firms

Figure 2-1 Firms sell goods and services paid by

households (consumption expenditures) Households must work to earn income to

pay for their consumption (income) Income and consumption are equal.

Figure 2-1 The Circular Flow of Income and Consumption ExpendituresFigure 2-1 The Circular Flow of Income and Consumption Expenditures

FIRMS(suppliers of goods and services,

demanders of factor services)

HOUSEHOLDS(demanders of goods and services,

suppliers of factor services)

The interdependence of goods and factor marketsThe interdependence of goods and factor markets

Q1

P1

QF2

PF2

Q2

P2PF1

QF1

D2D2

The interdependence of goods and factor marketsThe interdependence of goods and factor markets

P

Q

P

Q

RsRs RsRs

RsRsRsRs

Factorservices

Goods

GoodsFactor

services

S S

D1 D1

(1)Consumer

demand

(1)Consumer

demand

(4)Factor supply

(4)Factor supply

(3)Factor

demand

(3)Factor

demand

(2)Producer

supply

(2)Producer

supply

OO

Factorpayments

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)




Firms

Households

Factorpayments

Factorpayments





Investment (I)Investment (I)

Governmentexpenditure (G)

Governmentexpenditure (G)

Exportexpenditure (X)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

Netsaving (S)

GOV.

Nettaxes (T)

Nettaxes (T)

ABROAD

Importexpenditure (M)

Importexpenditure (M)


WITHDRAWALS

INJECTIONS

Leakages from the Circular Flow Leakages from the Circular Flow

Leakages (in terms of flow of payment)

money paid to the households but not returned to firm

Or flow of payments that started from firms but did not return back to firms

e.g. household savings, net taxes and imports

Injections into the Circular Flow Injections into the Circular Flow

Injections (in terms of flow of payment)

are revenue for firms not from sales to household

e.g. investment by firms, government purchases and exports

The Circular Flow of Income with Government and Foreign TradeThe Circular Flow of Income with Government and Foreign Trade

Government

spends money on goods & services (G)

finances welfare payments, i.e. transfer payments (B)

this spending is financed by tax (T)

Export (X)

made at home but sold abroad

Import (Z)

made abroad and bought at home

The Circular Flow of Income in SymbolsThe Circular Flow of Income in Symbols

Domestic Output (GDP) is either

Consumed (C)

Invested (I)

Bought by the Government (G)

Bought by the foreigners, net exports (X-Z)

Factor Incomes are spent on

Consumption (C)

Saving (S)

Paying taxes net of benefits (T-B)


GDP = C + I + G + (X – Z)

Factor Income = C + S + (T – B)

Since every things produced in the economy

generates equivalent factor income

Domestic Output (GDP) = Factor Incomes


Domestic Output

C + I + G + (X – Z) C + S + (T – B)=

Factor Incomes

C: Consumption I: Investment G: Government ExpenditureX-Z: Net exports

C: Consumed S: Savings T-B: Taxes Net of Benefits


Domestic Output

C + I + G + (X – Z) C + S + (T – B)=

Factor Incomes

rearrange

I + G + X S + (T – B) + Z=

Total Injections Total Leakages


rearrange

I + G + X S + (T – B) + Z=

S = I + (G – T + B) + (X – Z)

Government Net Expenditure

Net Export

GDP, GNP, DepreciationGDP, GNP, Depreciation

Gross National Product (GNP)

total income of citizens wherever it is earned

= GDP + Net Property Income (NPI)

Depreciation

wear and tear of capital stock

National Income (factor earnings)

= GNP – Depreciation


Nominal Gross National Product

Measures national output at current prices

= value of all goods at current prices

Real Gross National Product

Measures output at base year prices

e.g. value of todays national output at 1995 prices

Allows us eliminate the effect of price changes and see how real output evolves over time


GNP Deflator for year t =Nominal GNP for year t

Real GNP for year t

Changes in GNP Deflator allows us to isolate the effect of increasing prices on Nominal GNP


Consumption, injections, withdrawals

and equilibrium

Consumption, injections, withdrawals

and equilibrium

Income (Y) = labour services = consumption expenditures (C)

= product

Each of the four elements in the figure is a flow magnitude.

What transactions should be included in income and expenditure

National income and product accounts is the official government accounting of all flows of

income and expenditure in the country

Defining GDP

There are 3 major rules for including items in the total final product

Currently produced: a good must be currently produced, i.e., exclude all used items. It also excludes any transaction in which money is transferred without any accompanying good or a service; transfer payments (gifts from one person to another, gifts from the government to persons; social security, medical care and unemployment benefits), it also excludes capital gains accruing to persons as the price of their assets change.

Sold in the market. Goods must be sold in the market and valued at market prices. The value of personal time spent in activities that are not sold in the market are excluded (self consumption). Pollution cost allowances are excluded.

But not resold. A good must not be resold in the current time period. i.e., the good must be a final product not an intermediate product.

Components of Expenditure

Types of investment. Final goods that business firms keep for themselves are called private investments or capital formation.

They add to nation’s stock of income-yielding assets. There are two types of private investments.

Inventory investment. Unsold products stay in inventories. By including change in inventories as part of expenditure GDP is guaranteed to

equal total expenditure

Fixed investment. All final goods purchased by business firms other than additions to inventory. These are mainly structures (e.g.,

factories and houses), and equipments

Relation of investment and saving

The portion of household income that is not consumed is called personal saving. These funds are channeled to business firms in

two ways:

They buy business bonds or stocks

They deposit savings in financial intermediaries to be lent to business firms

Saving is a leakage from the income used for consumption expenditures. This leakage must be balanced by an injection on

non-consumption spending in the form of private investment.

Figure 2-2

Figure 2-2 Introduction of Saving and Investment to the Circular Flow DiagramFigure 2-2 Introduction of Saving and Investment to the Circular Flow Diagram

Net exports

Exports creates income in the country, but not part of the consumption and investment spending of residents

Imports are expenditures of residents for goods and services produced abroad and thus do not create domestic income

If income created from exports is greater than income spent on imports, the net effect is a higher level of domestic production and income. Thus, net exports is a component of a final product and GDP

Another name of net exports is net foreign investment, since net foreign investment (net exports) creates claims on foreigners. If Japanese exports to USA is greater than its imports from USA, US payments of the net exports will enable Japan to buy US assets including bank accounts in USA

GNP versus GDP

These two terms differ in their geographical coverage of GDP.

GDP covers goods and services produced within the borders of the country

GNP covers goods and services produced by labor and capital supplied by the country residents, whether takes place within borders of the country or in a foreign country

To convert GDP in GNP we must add in elements such as the income of domestic residents earned abroad and dividends they receive from abroad, then subtract income that is paid to foreigners (net foreign factors income)

The government sector

collects taxes from the private sector

Makes two kinds of expenditures

Purchase of goods and services,

Generate production and create incomeIt can also make direct payments to households.

Figure 2-3

Figure 2-3 Introduction of Taxation, Government Spending, and the Foreign Sector to the Circular Flow Diagram

Figure 2-3 Introduction of Taxation, Government Spending, and the Foreign Sector to the Circular Flow Diagram

The magic equation and the twin deficit

the magic equation helps us to understand the relationship among investment, private saving, the government surplus/deficit and the

NX

Implications of equality between income and expenditures:

Y ≡ E

E ≡ C+I+G+NX (1)

Personal income the households receive is production (Y) and transfer payments from the government (F). This is available for (C), (S) and

tax payments R. i.e.,

Y+F ≡ C + S + R

Or

Y ≡ C + S + R – F (2)

Or

Y ≡ C + S + T (3)

T (net taxes)

Leakages and Injections

Note that

C + S + T = C + I +G +NX

-C -C

S + T ≡ I + G + NX (4)

Leakages (S+T) must be exactly balanced by injections of non consumption spending (I+G+NX)

Equation 4 is the magic equation. Its technical name “the leakages-injection) identity”.

If there is a budget deficit (T-G) < 0 then,

I + NX – S < 0 (T-G)

The government budget and the twin deficits

Rearrange eq. 4 to show the uses of a government budget surplus

T – G = (I + NX) – S (5)

If T>G, there are 3 ways that a government budget surplus can be used

A budget surplus allows private savings to decline without a need for a decline of total investment

(I+NX).

A budget surplus can stimulate domestic investment (I)

a budget surplus can boost foreign investment (NX) or if NX is negative, reduce borrowing from

foreigners.

If T<G, the government is running a deficit, there are 3 implications

Budget deficit could make (I) smaller.

Budget deficit requires that (S) must rise to avoid any downward pressure on total investment (I+NX).

If S does not increase, to avoid a decline in (I+NX), there must be more borrowing from foreigners and a decline in lending to

foreigners.

e.g.,

T – G = (I + NX) - S

-1.8 = (17.8 – 1) – 18.4 (deficit financed by foreign borrowing (-NX), and S to be greater than I)

4.4 = (20.8 – 4) – 12.4 (surplus with greater borrowing (-NX) allowed I to increase to 20.8 greater than S)

-4.6 = (15.9 – 4.9) – 15.6 (deficit with greater borrowing allowed I to be greater than S)

How much income flows from business to households

Income leakages and the circular flow

Table 2-1

Summarize the steps by which income travels from business firms to households.

Net Domestic Product = GDP – depreciation

Now you may notice that gross or net depends on whether depreciation is included or excluded

Domestic income = NDP – indirect business taxes

Personal income = DI – undistributed profits – corporate taxes + transfer payments

Personal disposable income = personal income – personal income taxes

Table 2-1 Households Get What Remains After All the LeakagesTable 2-1 Households Get What Remains After All the Leakages

Nominal GDP, Real GDP and the GDP deflator

Real and Nominal Magnitudes

Nominal amounts are not very useful in economic analysis. They may rise because of a rise in Q or P.

When we spend more, it does not indicate that we consume more, if prices are rising. For this reason we eliminate the influence of

price changes.

Real GDP and Real output

Real GDP is expressed in the prices of an arbitrary base year. Year 2005 real output at the 2000 prices represents the amount that actual 2005 production have cost it had been sold at its 2000 prices. Nominal GDP of 2005>2000, and nominal GPD of 1995<2000

Figure 2-4

The ratio of nominal GDP to real GDP is a price index called Implicit GDP deflator.

How we measure real GDP and the inflation rate

We have to find someway to separate changes in nominal GDP caused by changes in real GPD and those caused by inflation.

Why we care about real GDP and inflation

Movements of real GDP indicate the changes in unemployment rate. It is also important to measure productivity.

Inflation is also important since very fast inflation can destroy a society; either because of the direct harm it causes, or

because of the indirect harm done by measures to stop it (e.g., higher interest rates).

How we calculate changes in real GDP

Output can’t be added together. the only way to combine these products is to place a value on each component of GDP. But since prices are constantly changing, the measures of GDP and its changes will depend on which time period we choose to take the

prices.

Table 2-2

The table shows a general tendency, that choosing the prices of a later year tends to give use of a lower

increase in real GDP, since a lower valuation on the quantities that have increased most rapidly.

Table 2-2 Calculation of Fixed-weight and Chain-weighted Real GDP and GDP Deflators in an Imaginary Economy Producing Only Oranges and Apples

Table 2-2 Calculation of Fixed-weight and Chain-weighted Real GDP and GDP Deflators in an Imaginary Economy Producing Only Oranges and Apples

A chain weighted calculation of real GDP

In the table above we there are two rats of growth of real GDP. A reasonable compromise is to average these two answers using the

geometric average.

The outcome is called chain-weighted real GDP, because the weights move forward from year to year.

Implicit deflator and the chain-weighted deflator

There are two different GDP deflators. The first, the implicit GDP deflator, is simply the ratio of nominal GDP to chain weighted real GDP.

Implicit GDP deflator = nominal GPD/real GDP

13.106.12.1( x

The second type of GDP deflator is calculated directly from the prices and quantities of goods and services in the economy,

then calculate the chain weighted GDP deflator.

The implicit and chain weighted GDP deflator give very a close answer.

Measuring unemployment

The unemployment survey

to calculate unemployment rate, it is impossible to collect information every month. As a compromise, each month 60000

households are interviewed. Each month one-forth of the sample is replaced.

The questions asked in the survey some questions such as:

What you doing most of last week. Anyone who has done any work at all for pay during the past week, whether part of full

time is counted as employed.

“did you have a job from which you were temporarily absent or on layoff last week”. Any person who is awaiting a recall from a layoff or has obtained a new job but waiting for it to begin is

counted as unemployed.

“have you been looking for work in the last 4 weeks and if so what have you been doing in the last 4 weeks to find a work”. A

person searching for a job by applying to an employer, registering with employment agency, checking with friends or

other specified job search activities is counted as unemployed.

The remaining people are not in the labor force: homemakers who don’t seek work, students, disabled, and retired people

Total labor force = civilian employed + armed forces + unemployed

Not in the labor force.

Actual unemployment rate = number of unemployed / civilian employed + unemployed

The labor force participation rate is the ratio of the labor force/population aged 16 or over.

Those who do not participate in the labor force include those who are above 15 and in school, retired, homemakers, could not

work because they are ill and disabled, those who have given up on finding jobs;

Flows in the definition

The unemployment rate by itself is not a measure of the social distress caused by the loss of a job.

The government concept misses some of the people hurt by a recession, e.g., cut in hours, enforcement to shift from full to

part time.

“Discouraged workers” or “disguised unemployment

For these reasons, official statistics understate the total amount of unemployment.

THANK YOU

CIRCULAR FLOW OF INCOME

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