The circular flow of income

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The circular flow of income

  • diagram for a fluctuation in GDP over time: boom -> recession -> slump -> recovery -> boom..
  • At times, a recession may be a small slowdown in the level of econ. activity; OR it could be worse and lead to high unemployment levels as in 1991 in the UK.
  • Similarly, a boom may be simply firms have more difficulty rcruiting labour; OR it may lead to rapid inflation, and a growing balance of payments deficit.
  • it is known that changes in aggregate expenditure lead to changes in economic activity.
  • national output = national income = national expenditure
  • the flow of money and income is circular as:
    • income earned by households allows them to buy g/s sold by firms
    • firms use the factors of production to produce g/s
    • households buy the g/s with money earned in working for firms
    • the money passes from firms to households and back
  • in reality, households don't spend all of their income on products of domestic firms and firms do not spend all their revenue hiring domestic factor services as seen in Fig12.4
  • This type of economy is known as a 'two-sector economy' as there is only investment and savings to consider. 
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  • investment represents an addition into the circular flow as it is revenue for firms that does not arise from spending of households, assuming that investment is only done by firms.
  • Savings are seen as a withdrawal as it is money put aside by both households and firms so is not passed on in the circular flow 
    • they are income induced
    • saving means reduced consumption/ expenditure by households/firms respectively, AD will decrease. This economy will be in equilibrium: injections = withdrawals/ I = S
  • if injections and leakages are unequal, the economy is in disequilbrium
    • this can occur when plans of firms and households differ: if consumers save more, firms will have unsold stocks.
    • If labour becomes unemployed, income will reduce so less spending and the economy will contract. The level of national income will fall, savings will fall (amount saved depends on level of income). 
    • if planned investment is GREATER THAN planned saving, it can lead to disequilibium. The extra investment injects additional income and the economy grows through the multiplier effect

** if planned saving > planned investment, national income falls (vice versa) and if equal then equilibrium

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  • evidence suggests that an injection causes a multiplier effect to operate and the increase in national income is likely to be larger than the initial injection. 
  • in a two sector economy, AD is th sum of planned investment + planned consumption. 
    • if AD > the level of national income the economy will grow and national income will increase
    • if AD is < national income, the economy will contract and national income will fall.
    • in a two sector economy equilibrium occurs when: planned injections = planned withdrawals, investment = savings, AD = income (C+I)
  • Three-sector economy introduces the government sector: deals with both injections, leakages
  • govt. expenditure (G) is an injection as it does not arise through spending of households.
  • G may benefit:
    • firms that win contracts or receive income from govt. spending
    • households through employment in public sector or through transfer payments e.g. child allowance
  • Taxes (T) affect firms AND households and reduce the amount they can spend. (leakage)
  • The result of G on national income will depend on 'net government spending'. This is announced in the Budget where the Chancellor of the Exchequer  explains the relationship between G and T. 
  • In a three sector economy, equilbrium occurs where: planned injections = planned withdrawals, I + G = S + T or AD = C + I + G 
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  • four sector economy: includes foreign trade (imports and exports) so is no longer a closed economy because it involves international trade. 
  • Imports, M, are a withdrawal - spending by firms and households, that is not passed in the circular flow.
  • Exports, X, are an injection - originate outside the flow and increase the size of the national income
  • the overall effect of foreign trade depends on the overall balance. 
  • In a four sector economy, the overall level of econ. activity depends on:
    • whether the sum of injections = the sum of withdrawals (national income in equilibrium)
    • if AD = income where AD = C + I + G + (X-M)
    • if the sum of injections > the sum of withdrawals, then the level of national income is rising
  • some items in the circular flow e.g. C, I and S: X and M, depend on households and firms so there can be quite volatile changes in AD. This instability could lead to large changes in national income and cause fluctuations in the economic cycle. 
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  • Fiscal policy: govts could counter balance changes in the private sector by changing the public sector: mnipulating taxation and govt expediture.
  • changes in AD could come from changes in injectios/ withdrawals or consumer spending.
  • an increase in expenditure will lead to an increase in the level of employment that will further increase spending, business expectations will improve and so firms will increase investment. 
  • increased AD could lead to a higher rate of inflation if AD is > AS. increases in income and inflation could lead to an increase in imports, leading to a balance of payments deficit. 
  • a reduction in AD due to: increase in withdrawals or a fall in injections and consumption causes:
    • the level of national income to fall so consumption will decrease.
    • firms will reduce output to avoid excess supply. They will 'lay off' labour and unemployment will rise
    • business expectations will become negative.
    • amount spent on imports will fall anf firms will try to export more to make up for the loss of business at 'home' 
    • govts. income from taxes will fall and expenditure on things like JSA and benefits will rise.
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the importance of consumption

  • private consumption is about 60% of aggregate expenditure.  
  • consumers are left with their disposable income, after paying taxes etc. This can either be spent or saved or both. 
  • on average, a higher % of income is consumed when income is lower.

changes in consumption:

  • the wealth effect - consumers change the level of consumption with a change in wealth. e.g. rise in the value of house prices or a change in the value of financial assets
  • inflation - if inflation is expected, it should lead to increased consumption as consumers know that g/s will be dearer n the future so will buy them now - 'anticipatory buying'
  • if inflation continues or rises it has a negative wealth effect i.e. reduced wealth so consumers will save more to restor value of their wealth.
  • rate of interest - changes here, change the cost of borrowing and affect level of consumption. As it rises, consumers will save more and when it fall, will borrow more. Also, when interest rates are low, firms will invest more.
  • expectations - positive expectations e.g. a possible promotion at work can increase consumption while negative expectations e.g. fears of job loss will increase saving.  
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