EconomicsCombined Version

Edwin G. DolanBest Value Textbooks

4th edition

Chapter 18The Circular Flow

ofIncome and Expenditure

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

circular flow of income and expenditure for the simplest possible economy.

• 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.

Measures of Production: GDPGross Domestic Product (Gross Domestic Product (GDPGDP)) 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 since these do not reflect production.

Must be produced within the geographic boundaries of the country.

Net additions to inventory are current period output so are also included.

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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, the excess tax revenue is used to repay previous debt

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 + XN

( GDP = C + I +G + XN )

• We avoid double counting/ inappropriate counting by subtracting imports from total measured expenditures; so XN = Exports - Imports

GDP = C + I +G + XN

• 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

• XN = Net Exports (Exports – Imports)

Planned Expenditure (Ep)

• Planned investment (Ip) consists of two components:

fixed investment + unplanned inventory investment

• Total planned expenditure is given by the following equation:

Ep = C + Ip + G + XN

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

• 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 (Spending that is determined independent from income levels/GDP)

– By how many dollars does real GDP change for every dollar change in autonomous expenditures?

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

MPIMPS 1

leakages1

Multiplier

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.

Computingthe Spending Multiplier

MPIMPS 1

leakages1

Multiplier

If MPS = 0.30 and MPI is 0.10, then MPS + MPI = 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 GapRecessionary gap

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

multiplier spending

gap GDP gapry Recessiona