Topic 1: National Accounting, Keynesian Income-Expenditure Model and Fiscal Policy

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1 Topic 1: National Accounting, Keynesian Income-Expenditure Model and Fiscal Policy The Circular Flow of Income and Expenditure Circular flow of income and expenditure is a simple representation of the macro economy Assumes that: o Value of output produced by firms = value of expenditures by participants in the economy o Value of output produced by firms = total income generated in economy and flowing to households o All inputs to production ae privately owned by households (not govt.) Circular Flow in Four-Sector Economy Factor market: market for inputs i.e. labour, capital and resources (minerals, land) Goods market: consumer and capital goods (goods that produce other goods) Financial market: financial markets and securities Basis for national accounting identity i.e. to determine GDP Firms Households i.e. households receive income o Firms must hire factors of production/inputs o Requires income payments for hiring i.e. payments (wages), profits (interest), rent, natural resources o One way to measure GDP i.e. income approach measuring these income flows on a quarterly basis Households Firms i.e. expenditure and revenue flows o Consumption expenditure promotes production of consumer goods i.e. output of firms revenue flows to firms depends on household income o Investment expenditure expenditure on capital goods/investment goods used to produce other goods firms produce and buy these goods Injection into circular flow exogenous from income promotes production in economy system form of demand Financial Markets Firms

2 o Financed from borrowing for investment from financial markets shares, issues, debentures, borrowing from the bank Households Financial Markets o Investment expenditure depends on saving of households and thus household income holding money/deposits, buying shares, etc. leakage in circular flow o Saving diverts income away from stimulating production Government Goods Market o Government expenditure promotes production e.g. infrastructure promotes production as it makes it profitable for firms to increase output creates demand injection to circular flow contributes to revenue flowing to firms o Assumption: exogenous to income doesn t depend on household income Households Governments o Net taxes = welfare payments taxes o Government expenditure doesn t include welfare payments o Net taxes are a leakage reduces disposable income for households doesn t promote production in economy Open economy: Rest of the world goods market o Net exports = exports imports o Imports are leakage promotes production of goods in foreign countries Open economy: Financial markets rest of the world o Foreign borrowing/lending export surplus (lender), export deficit (borrower) Injections and Leakages Private Sector: private investment is an injection while saving is a leakage Government Sector: government expenditure is an injection and net taxes (T) is a leakage (where T = Taxes Transfer Payments) Overseas Sector: exports are an injection and imports a leakage National Accounting Identities AD C + I + G + (X M) Y C + S + T Equate (1) and (2) if output = AD, I + G + X M = S + T Injections (J) = Leakages (L) o I + G + X = S + T + M Hence, if we assume AD = output, then injections = leakages by definition Types of Investment (I) Inventory investment is the change in stock of raw materials, parts and finished products held by businesses o Any goods that are unsold are counted as part of inventory investment o Often used as an indicator of the economy o Many firms hold inventory for anticipated demand Gross fixed investment includes all final goods (mainly structures and equipment) purchased by businesses not intended for resale o Houses and condominiums owned by households are also counted as fixed investment according to national accounts o Gross fixed investment depreciation = net investment (adds to productive capacity of economy)

3 Composition of Australian GDP, 2008 For most advanced economies, consumption is 55-60% of GDP Often 15-20% is investment High non-residential investment (16%) due to mining boom Australia depends on trade high exports 21% Macroeconomic Equilibrium From exposition of national accounting, it is evident that real aggregate output is equal to real national income and is equal to real aggregate expenditure National accounting identity: Y AE (ex poste realised) In a simple two-sector model with only firms and households: o C + S C + I (ex poste) i.e. disposable income (Y) = expenditure o S I (ex poste) i.e. leakages = injections Actual levels of investment and saving must be equal when actual income and aggregate expenditure are equal (by definition) Not the same thing as national accounting identity Macroeconomic equilibrium (ME): position of stability in which economic forces tending to push the economy systematic and consistent o Centre of gravity in which economic system is tending toward/oscillating around Not a position at which the actual economy can be in o No theory can provide an explanation of the actual economy given its complexity ME is a position at which plans of agents are realised or are compatible collectively o In two-sector model, equilibrium output characterised by equality between planned investment and planned saving o In three/four-sector models, ME is characterised by equality between injections and leakages o Plans of agents collectively realised doesn t change behaviour of economy Equilibrium v Disequilibrium Equilibrium: I p = S p (ex ante) o Investment decisions undertaken by firms o Saving decisions undertaken by households Decisions undertaken by different groups of economic agents with different motives Collectively saving plans and investment plans will not automatically match Disequilibrium: I p S p o Possible even though S I (ex poste) due to S p S and/or I p I

4 o Agents investment/saving plans not realised causing them to change behaviour (i.e. decision making) o Equality between planned saving and planned investment corresponds with equality between aggregate expenditure and output (and income) S P = Y C p o Planned saving = income planned consumption In equilibrium: S p = I p o Planned savings = planned investment Then, AD = C p + I p (aggregate demand) o Y = C p + S p (disposal of income) Thus, when I p = S P, then AD = Y Macroeconomic Equilibrium v Disequilibrium Equilibrium condition: I p = S p AD = Y Disequilibrium: I p S p AD Y Assume consumption-saving plans of households are realised: o C P = C and S P = S o Planned consumption = actual consumption and planned saving = actual saving o If people have income and want to buy consumer goods, they can o Hence, disequilibrium falls on firms investment plans not being realised because we re assuming consumption and savings plans of households are good o In short-run, reflected in changes in inventory stocks Given that S I, then disequilibrium I p I o Where I = I P + I U Planned inventory and unplanned inventory (undesired changes in stock) o I U = Y AD If output > AD, unplanned investment is positive i.e. inventory levels higher than desired levels, producing more goods than being bought If AD > output, unplanned investment is negative i.e. inventory levels falling below desired levels, firms output not keeping up with AD, stock is declining firms increase output to increase stock So that equilibrium position is when: o I U = 0; Y = AD; I P = S P Macroeconomic Disequilibrium Two cases of macroeconomic disequilibrium: 1. Excess Aggregate Supply Y>AD and S p > I p o Where Y C P > I p Y > C P + I p o Therefore, S p S I and S P = I p + I u, then I u > 0 o Inventory levels are rising 2. Excess Aggregate Demand Y<AD and S p < I p o Where Y C P < I p Y < C P + I p o Therefore, S p I p + I u and then I u < 0 o Inventory levels are falling

5 Keynesian Quantity Adjustment Process Adjustment process via quantity changes to equilibrium supposes that output adjusts to aggregate expenditure (or demand) based on: o (1) The economy is dominated by industrial manufacturing and services production o (2) There is no existing capacity constraint on raising output below fullemployment (i.e. no resource constraint) A. Adjustment from Excess Supply Disequilibrium because AD = 190 (C p + I P), Y = 200 (C + I P) o I U = 10, too much stock on hand, firms cut back production o Quantity adjustment less workers, less inventory, don t want to carry unsold goods not profitable Expected consumption > households planned consumption excess supply of inventory cut back production B. Adjustment from Excess Demand Disequilibrium because AD = 210 (C p + I P) and Y = 200 (C+I p) o Inventory stocks falling below desired levels o Quantity adjustment firms expand production Expected consumption < households planned consumption excess demand for inventory increase production to meet demand