Business Environment 2 Week 2 Circular Flow of Income 1
Learning Objectives To understand the concepts of circular flow of income To bring out the relationship between the four macroeconomic objectives and the circular flow of income To know how aggregate demand affects the macroeconomic objectives 2
Macroeconomics and microeconomics Macroeconomic theory: It deals with the aggregate behavior of the economy as a whole. It studies the problems of determination of the level of national income, prices and the rate of interest. It tries to explain why there are changes in the level of national income and what accounts for economic growth. 3
Macroeconomics and microeconomics Microeconomic Theory: The microeconomic theory, on the other hand, deals with the behavior of individual markets of different goods and services. It explains the behavior of household, firm and industry taking part in the particular markets of a particular commodity. While explaining such particular markets, it deals with the question of how the resources are allocated among different branches of the economy and how income is distributed among different factors of production. 4
Major Macroeconomic issues Economic growth: A growing economy means that there will be more goods and services for people to consume. Inflation: By inflation we mean a general rise in prices throughout the economy. Unemployment The balance of payments and exchange rate: The final issue has to do with the country s foreign trade and its economic relationships with other countries. 5
Government Macroeconomic Policy High and stable economic growth Low unemployment Low inflation The avoidance of balance of payments deficits and excessive exchange rate fluctuations 6
Aggregate Demand (AD) Aggregate Demand (AD) is the total level of spending on goods and services in the economy. 7
Aggregate Demand (AD) Aggregate Demand controls four elements: Consumer spending on domestically produced goods and services (C d ), Investment by firms (I), Government spending (G), and The expenditure of foreigners on the subject country s export (X); less any expenditure on foreign goods and services (M). Therefore, AD = C+I+G+X-M. 8
Economic Sectors The economy is divided into 4 Sectors: 1. Households 2. Firms 3. Government 4. Foreign sector 9
1. Households Households: Households consist of consumers. They provide the factors of production, or resources used in production. What are the factors of production? (Land, labour & capital) 10
2. Firms Firms: This sector consists of the organizations (companies) that produce goods and services 11
3. Government Government: It is also known as the public sector. It consists of the economic activities of government. 12
4. Foreign Sector Foreign Sector: This comprises the economic activities of people outside the domestic economy 13
Circular Flow of Income How to analyze the interaction of the 4 economic sectors? The usual way of analyzing the interaction of these sectors is a model known as the circular flow of income 14
Circular Flow of Income The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange. Money has facilitated the process of exchange and has removed the difficulties of the barter system. Thus, money acts as a medium of exchange. The households supply the economic resources or factors to the productive firms and receive in return the payments in terms of money. It is thus clear that, in the monetary economy, there will be flows of money corresponding to the flows of economic resources and the flows of goods and services. But each money flow is in opposite direction to the real flow. 15
Circular Income Flow in a Two Sectors Economy Fig.2.1 16
Circular Income Flow in a Two Sectors Economy In Fig.., in the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits. In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households. Thus there is, in fact, a circular flow of money or income. 17
Circular Flow of Income Fig.2.2 The circular flow of income INJECTIONS Factor payments Consumption of domestically produced goods and services (C d ) Investment (I) Export expenditure (X) Government expenditure (G) BANKS, etc GOV. ABROAD Net saving (S) Net taxes (T) Import expenditure (M) WITHDRAWALS 18
Circular Flow of Income On the left side, the firms pay to household money in terms of wages, salaries, and dividends from investments, interest, and rent. These are payments for factors of production (e.g. labour, capital, and land) which are supplied by the households. Money flows from firms to households as factor payments. On the right side, households pay money to firms as payment for domestically produced products and services consumed by households. Granting that households spend all their income and firms pay all its income they received from consumers; and if the speed at which the money circulates does not change, the movement will continue indefinitely unchanged in the inner flow. However, this does not happen in reality because there withdrawals and injections as indicated in the diagram. 19
Withdrawals & Injections Withdrawals (W) are incomes of households which do not pass through the inner flow (e.g. net savings [S], net taxes [T], export expenditures [M]). Thus, W=S+T+M Injections (J) are expenditures on the production of domestic firms coming from outside the inner flow (e.g. investments [I], government expenditures [G], export expenditures [X]). Thus, J=I+G+X 20
The components of withdrawals The households spend only part of the income received on the goods and services of domestic firms. The rest of the income will be withdrawn from the inner flow. There are 3 forms of withdrawals: 1. Net Savings (S) 2. Net Taxes (T) 3. Import expenditure (M) 21
The components of Injections Only part of the demand for firms output arises from consumer expenditure. The rest comes from other sources outside the inner flow. These additional components of aggregate demand are known as injections. They are: 1. Investment (I) 2. Government Expenditure (G) 3. Export Expenditure (X) 22
GDP (Total Output) Y = C + I + G + X M Y = Expenditure C = Total consumer expenditure (spending) I = Investment G = Government expenditure X = Exports M = Imports X M = Net exports 23
Circular flow and the 4 Macroeconomic Objectives What are the effects of aggregate demand on the four macroeconomic objectives: There will be economic growth. The greater the initial excess of injections over withdrawals, the bigger will be the rise in national income; Unemployment will fall as firms take on more workers to meet the extra demand for output; more people will be employed by the firms in order to meet aggregate demand. 24
Effects of Aggregate Demand Inflation tend to rise. The greater the rise in aggregate demand relative to the capacity of firms to produce, the more firms will find it difficult to meet the extra demand, and the more likely they will raise prices. Exports and imports as part of the balance of payments will tend to deteriorate. The high demand will invite more imports, and high domestic inflation will make exports less competitive, and domestic products will be more expensive than imported. As a result, import will tend to rise as export will tend to fall. Equals balance of payment deficit. 25
Injections > Withdrawals The ideal is Injections = Withdrawals But, what happens to the four objectives if planned injections exceed planned withdrawals? national income will rise unemployment will fall inflation will rise imports will rise export will fall 26
Injections < Withdrawals What happens if planned injections are less than the planned withdrawals? National income will fall. Unemployment will rise. Inflation will fall. Imports will fall. Export will rise. 27