Circular Flow

CAPS requirements• The open economy circular flow model• The markets• National account aggregates and conversions• The multiplier:– Definition of multiplier effect– Explanation of the multiplier process aided with a

circular flow and examples

The participants in an open circular flow model

Households: owners of the factors of production.

• Households offer FOP to firms

• Firms use FOP to produce goods and services

• Households receive income(rent, wages and salaries,interest and profit.) from firms in exchange for FOP.

• Households use this income to buys goods and servicesin the goods market.

Firms: use factors of production to produce good & services

Firms buy FOP’s from households in exchange for income (rent, wages and salaries, interest & profit).

Government: national, provincial and local

Gov. supplies goods/services to households and also taxes households and firms.

Foreign sector: countries in the rest of the world.

Important for imports and exports

The markets in an open circular flow model

Factor market

HOUSEHOLDS (FOP) FIRMS (income)(land, labour, capital, ent.) (salaries and wages, interest,

rent, profits)

Goods market Firms sell goods/services to households, other firms and the foreign sector.

Financial market Money and capital markets. Surplus funds deposited & loans are made in the financial market.

Real flows – flows of physical things.

Money flows – aka nominal flows consist of the flow of money.

Leakages: factors that cause a decline in the flow of spending, income and production.

Savings (S), taxes (T) & imports (M). Decreases the flow of money and the total spending in the economy.

Injections: factors that cause an increase in the flow of spending, income and production.

Investment (I), government spending (G) & exports (X).

A two-sector (closed)model

Spending, production and income flows

INCOME FLOWRent, wages/salaries, interest and profits to households from firms.

PRODUCTION FLOWConsists of consumer goods/services and capital goods.

SPENDING FLOWTotal spending undertaken by households (consumption) and firms (investment). TS = C + I

Spending on goods and services (TS) = what is being produced (TP) = what is paid out as income (TI) to FOP used in production.

The total spending in the model is equal to:TS = C + I = 800 + 200 = 1 000

TS = TP = TIY = 1 000

C = 800 Y = 1 000S = Y – C = 1 000 – 800 = 200S is a leakage I is an injection

Equilibrium since S = I

A three-sector model

From this three-sector circular flow we can see that…

• Demand for goods/services in our economy consists of C + I + G

• Flows of spending, production and income are equal.

• 2 leakages: savings (S) and taxation (T).• 2 injections: investment spending (I) and

government spending (G).• In equilibrium leakages = injections (S + T = I +

G)

TS = C + I + G = 900 + 200 + 100 = 1 200TS = TP = TIY = 1200Yd = Y – T = 1 200 – 50 = 1 150S = Yd – C = 1 150 – 900 = 250Total leakages

S + T = 250 + 50 = 300Equilibrium since S + T = I + GTotal injectionsI + G = 200 + 100 = 300

The four-sector model (open circular flow)

From this four-sector circular flow we can see that…

• Demand for goods/services in our economy consists of C + I + G + (X – M)

• Flows of spending, production and income are equal.• 3 leakages: savings (S) and taxation (T) and imports

(M).• 3 injections: investment spending (I) and government

spending (G) and exports (X).• In equilibrium leakages = injections (S + T + M = I + G + X)

TS = C + I + G + (X – M)= 850 + 200 + 100 + (100 – 120)

= 1 130

TS = TP = TIY = 1 130Yd = Y – T

= 1 130 – 50 = 1 080S = Yd – C

= 1 080 – 850 = 230Leakages = S + T + M

= 230 + 50 + 120= 400Injections = I + G + X

= 200 + 100 + 100 = 400

National account aggregates and conversions

National accounts: accounting records of a country’s total production, income and expenditure. Calculated by using the circular flow model.

3 methods of calculating GDP…1. production method – gross domestic product GDP(P)

or GDP2. income method – gross domestic income GDP(I) or

GDI3. expenditure method – gross domestic expenditure

GDP(E) or GDE

Production method: Gross domestic product (GDP)

Gross domestic product (GDP): total value of final goods and services produced within the country in a given period.

What is the total value added of these four transactions?

• A farmer produces 1000 bags of wheat which he sells to a miller at R10 per bag, yielding a total of R10 000.

• The miller processes the wheat into flour, which he then sells to a baker for R12 500.

• After baking bread with the flour, the baker sells it to a shop for R18 000.

• The shop subsequently sells the bread to final consumers for R21 000.

R61 500

Must differentiate between final and intermediate goods – avoids double counting.

Expenditure method: Gross domestic expenditure (GDE)

Gross domestic expenditure (GDE): total value of spending on final goods and services within the borders of a country.

GDE = C + I + G

Income method: Gross domestic income (GDI)

Gross domestic income (GDI): measures income earned by the FOP in the production of the GDP of a country.

GDI measures income of all the people (citizens and foreigners) within the borders of a country.

GNI measures income of all SA citizens even outside the borders of SA.

Factor Prices (cost), Basic Prices and Market Prices

Factor prices to basic prices

Used when GDP is calculated according to factor cost.

Differs from production approach because of taxes and subsidies on production not reflected in the factor prices.

Solution…ADD taxes on productionSUBTRACT subsidies on production= BASIC PRICES

Basic prices to market prices

Used when the GDP is calculated according to the production approach.

Basic price differs from market price due to tax/subsidy on the product.

Tax on products cause market price > basic price.

Subsidies on products cause basic price > market price.

Solution…ADD taxes on productSUBTRACT subsidies= MARKET PRICES

Factor Prices (cost), Basic Prices and Market Prices

Do all methods give the same answer?

• Farmer to miller for R50• Miller to Baker for R100• Baker to Consumer for R150

Expenditure method = R150• Value of final output

Production (value added method) = R50 + R50 + R50 = R150

Income method = = R50 + R50 + R50 = R150• Value added = income earned by FOP

Summary…

The multiplierThe multiplier: an initial change in spending changes the level of output and income by more than the initial change in spending.

The multiplier in the circular flow model1. R1000 investment (buy capital goods from local firm)2. Total production

increases by R1 000 → increase R1 000 in income. 3. Households save 20% (marginal propensity to save)

Spend 80% (marginal propensity to consume)4. Firms increase production by R800.

More FOP employed – household income increases by R800.5. Increase in C of R640 (80% × R800 ).

Further increase in production and income of R640.

6. Final increase in total spending, production and income = R2 962

(R 1 000 + R 800 + R 640 + R512)

8.Multiplier = 1 1 – 0,8 = 5

What is the marginal propensity to save in each scenario, and what is its effect?

Aggregate Expenditure ModelTwo sector economy: AE = C + I

Income (Y)

In equilibrium (E); C + I = Y

AE = Y

I.e. Amount spent by households (C) & Firms (I) = income earned by households (Y)

When AE < Y inventories accumulateWhen AE > Y inventories fall

AE = Y

Y2 Y Y1

Example: I increases by R5 millMPC = 0.75 ∴multiplier = 4Example: I increases by R5 millMPC = 0.75 multiplier = 4 ∴Y increases by R20 mill

MPC = 0.75What is the new level of Y?

Y

ANSWER = 120

What is the multiplier?What is the MPS?

Multiplier = 10MPS = 0,1

MPS =0.2How much did AE go up by?AE increased 4