Circular flow of income

INTRODUCTION TO MACROECONOMICSMODULE - IFY.BBA SEMESTER II

Course ContentModule I - Introduction: concepts and variables of macroeconomics, circular flow of income and expenditure.Module II National income and its determination National Income Aggregates, measurement of national income. Module III Classical Model of Income determination Says Law, Output & Employment in the Classical Model, Criticism of the Classical Model.Module IV Keynesian Model of Income Determination aggregate Demand in two, three and four sector economy, determination of equilibrium income, shifts in aggregate demand and the multiplier.

Course ContentModule V Analysis of the monetary sector : Evolution and forms of money, functions of money, theory of money supply, measures of money supply in India, demand for money and rate of interest.Module VI IS-LM framework goods and money market equilibrium, shifts in Is & LM curves, role of monetary and fiscal policy, aggregate demand - aggregate supply analysis.

Course ContentModule VII - Inflation & unemployment: Causes of inflation, inflation & interest rates, economic and social costs of inflation. Unemployment natural rate of unemployment, frictional and structural unemployment. Phillips curve, the trade off between inflation and unemployment, sacrifice ratio.Module VIII - Open economy: Foreign exchange market, fixed & flexible exchange rate system, balance of payment, Mundell Fleming with fixed & flexible exchange rates, role of fiscal & Monetary policy in an open economy

Reference booksMacroeconomics: Theory & Policy by Vanita Agarwal Macroeconomics by Dornbusch, FischerMacroeconomics by Mankiw, N Gregory Macroeconomics by M.C. VaishThe Macroeconomy today by Bradley. R. Schiller

Macroeconomics??Macroeconomics is the study of how the national economy as a whole grows and the changes occur over time. Thus it analyses the big or the macro picture. It deals with aggregates.

Scope & Importance of Macroeconomics Consumers, firms and governments take into account economic conditions in making their decisions. Macroeconomics involves study of

Economic Policies Level of UnemploymentPrice levelsMonetary ProblemsBusiness CyclesTrade performance National Income & Economic Growth

Macroeconomic PoliciesFiscal PolicyMonetary PolicyExchange Rate PolicyTrade Policy Price and Income Policies

Basic Concepts in MacroeconomicsStock and Flow Concepts: A stock variable is measured at a specific point in time it signifies the level of a variable at a point in time Money supply, unemployment level and foreign exchange reserves are examplesA flow variable is measured over a specific period of time- it represents the change in the level of a variable over a period of timeGDP, inflation, exports, imports, consumption and investments are examples

Basic Concepts in MacroeconomicsEquilibrium is state of balance or a state where there is no change.Partial and General Equilibrium: Partial equilibrium analysis involves determination of equilibrium price and output in each market, ceteris paribus.General equilibrium approach involves a state where all the markets and the decision making units in the economy are in a simultaneous equilibrium.

Circular Flow of National Income

It provides a macroeconomic framework used for analyzing macroeconomic relationships.It involves a process through which money and goods move between the different sectors in the economy.Firms are engaged in the task of production by combining different factors of production (La,L,K,E). Households are the owners (suppliers) of these factors and thus receive factor payments.This concept can be analyzed through different models. Two sector with/ without savings, Three sector and Four sector.

Circular flow of income in a Two Sector Economy without savingsIn a two sector economy there are only two sectors, households and firms. There is no government intervention and there are no international transactions i.e. no exports and imports making the economy a closed economy. Assumptions are as follows:Households spend all their incomes on the purchase of goods and services produced by the firms. In other words there are no savings by the household sector.Firms produce the goods demanded by the households. However the production by the firms is just enough to satisfy the demand by the households. In other words there are no inventories.The firm distributes all that it earn from the sale of goods as wages, interest, profit and rent. Thus there are no retained earnings by the firms.

Circular flow of income in a Two Sector Economy without savingsServices of Labor, Capital, NaturalResources and Entrepreneurial AbilityFactor payments: Wages, Interest, Rent & ProfitConsumption Expenditure for Goods and ServicesFlow of Goods and Services HouseholdsFirmsY = C

Circular flow of income in a Two Sector Economy without savingsObservations:There two loops: Inner and Outer. The inner loop represents money flow in the form of factor payments and consumption spending and outer loop represents physical flow in the form of factor services and flow of goods and services.There are two markets: Factor and Commodity marketsY= C

Circular flow of income in a Two Sector Economy with savings and investmentIn this two sector economy there are three sectors, namely households, firms and financial system. There is no government intervention and there are no international transactions i.e. no exports and imports making the economy a closed economy. This model takes into account savings by the households and how it comes back in the economy in the form of investment. When households save, their expenditure on goods & services decline to that extent and as a result money flow to the business firms will contract. Factor payments such as wages to workers will reduce and this will lead to the fall in total income of the households. Thus savings reduce the money flow and hence called a leakage in the circular flow.

Circular flow of income in a Two Sector Economy with savings and investmentBut savings need not lead to reduced aggregate spending and income if they find their way back into flow of expenditure. In any economy there exists set of financial intermediaries such as banks, insurance companies, stock markets where households park their savings. All these intermediaries together are called financial system. It is business firms that borrow from this system for investment in capital goods such as machines, factories, tools and instruments, trucks. Firms spend on investment in order to expend their productive capacity in future. Thus, through investment expenditure, savings of the households, are again brought back into circular flow and thus investment is called an injection in the circular flow which increases the flow of money.

Circular flow of income in a Two Sector Economy with savings and investmentCircular flow of money with saving and investment is shown in the diagram where in the middle part a box representing financial system is drawn. Money flow of savings is shown from the households towards financial system. Then flow of investment expenditure is shown as borrowing by business firms from the financial system.Assumptions are as follows:Households save in financial assets (productive) only.Households do not hold cash.

Circular flow of income in a Two Sector Economy with savings and investmentServices of Labor, Capital, NaturalResources and Entrepreneurial AbilityFactor payments: Wages, Interest, Rent & ProfitConsumption Expenditure for Goods and Services (C)Flow of Goods and Services HouseholdsFirmsFinancial systemSavings (S)Investment (I)Y = C + S

Circular flow of income in a Two Sector Economy with savings and investmentObservations:There are two flows: Money flow in the form of factor payments and consumption spending and Physical flow in the form of factor services and flow of goods and services.There are three markets: factor and commodity and financial marketsThere is a leakage in the form of saving which is equal to injection in the form of investmentY= C + S, Y = C + I

Circular flow of income in a Three Sector Economy or a closed economyThis model includes transactions between the households, firms and government making it more realistic. Government receives revenue from taxes levied on the households and firms. Tax payments reduce the disposable income of households and firms which in turn reduce their expenditure and savings. Thus T = TH + TF.Government has to incur expenditure on many heads from tax revenues. They include administration, justice, defense, subsidies and so on. These expenditure can be divided under four heads:Payments made to the household sector for the services rendered by them; for e.g. for those working in the armed forces, civil services and others

Circular flow of income in a Three Sector Economy or a closed economyPayments made to the firms for the goods and services bought from themSubsidies given to the firms to encourage production in certain sectors and areas in the economy.Payments made for social security and welfare; these include pensions, unemployment compensations and other transfer payments. G = GH + GF + GS + GT In the circular flow of income in a three sector economy money spent by the government is an injection which in turn is received by households and firms. Thus leakages arise in the form of saving and taxes which get injected in the form of investment and government expenditure.

Circular flow of income in a Three Sector Economy or a closed economy Assumptions:Taxes are the only form of revenue for the governmentFour sectors namely households, firms, financial system & governmentNo international TransactionsGovernment has a balanced budget i.e. T = GObservations:There are two flows: Money flow in the form of factor payments and consumption spending and Physical flow in the form of factor services and flow of goods and services between households and firms. There is an additional flow between government and the financial system.There are three markets: factor, commodity and financial marketsY= C + S + T, Y = C + I + G, leakages are equal to injections.

Impact of government budget on Circular flow of incomeGovernment may follow a balanced, deficit or surplus budget. In case of a balanced budget where government expenditure is equal to government revenue or G = T, the amount of income withdrawn from the circular flow as taxes re-enters the flow as government expenditure.In todays world government often follows deficit budget G > T, This difference is financed by taking loans from the financial sector. Such a budget implies net injections in the economy and thus an expansion in the circular flow of income.In a surplus budget the government expenditure is less than their revenue G < T. Such a budget implies net leakages and thus a contraction in the circular flow of income.

Circular flow of income in a Three Sector EconomyServices of Labor, Capital, NaturalResources and Entrepreneurial AbilityFactor payments: Wages, Interest, Rent & ProfitConsumption Expenditure for Goods and Services (C)Flow of Goods and Services HouseholdsFirmsFinancial systemSavings (S)Investment (I)Y = C + I + GGovernmentGovernmentWages, Salaries & Transfer PaymentsGovernment purchases of goods and services & SubsidiesTaxesTaxes

Circular flow of income in a Four Sector Economy or an Open economyObservations:Equilibrium in all three sectors: S=I, X=M & G=TS + T + M = I + G + X, leakages are equal to injections.Assumptions:Only Households and firms deal with the rest of the worldBoth the sectors have exports and importsFive sectors namely households, firms, government, foreign countries and financial systemExports and imports of goods and services only, excluding foreign investments and lending and borrowing.

Circular flow of income in a Four Sector EconomyServices of Labor, Capital, NaturalResources and Entrepreneurial AbilityFactor payments: Wages, Interest, Rent & ProfitConsumption Expenditure for Goods and Services (C)Flow of Goods and Services HouseholdsFirmsFinancial systemSavings (S)Investment (I)Y = C + I + G + (X-M)GovernmentGovernmentGovt purchases of goods and services & SubsidiesTaxesTaxesForeign CountriesForeign CountriesPayment for exportsExpenditure on imported goods & ServicesWages, Salaries & Transfer Payments Payment for Labor servicesPayment for imports

Circular flow of income in a Four Sector EconomyWhen a country imports goods and services, the expenditure incurred by the residents of the domestic country leads to an increase in the income of the factors of production of the country exporting the goods and services. Hence imports lead to an outflow of income and hence to a decrease in the circular flow of income.When a country exports goods and services, the expenditure incurred by the residents of the foreign country leads to an increase in the income of the factors of production in the domestic country which is exporting the goods and services. Hence exports lead to an inflow of income and thus an increase in the circular flow of income.

Leakages and Injections in the economyLeakage is an income which is generated in the production of the national output and which does not become a par of the circular flow of income. There are three types of Leakages: savings, taxes and imports.Injection is an amount of money which is spent by different sectors in the economy and which is in addition to their incomes generated in the circular flow of income. Leakages and Injections in the economyIn equilibrium leakages are equal to injections and the size of circular flow remains the same.

Leakages and Injections in the economyIf I > L, the circular flow will grow and economy will proper.If L >I, the circular flow will become smaller in size and there is recession in the economy.For household sector, leakages take the form of savings, personal income tax, sales tax and imports whereas injections include government expenditure.For firms leakages take the form of corporation tax, business taxes and business savings, imports whereas injections include government expenditure, investment expenditure and export of goods and services.

Importance of Circular Flow of IncomeHelps in understanding smooth functioning of the economyHelps to know the problem of disequilibrium and guides in restoration of equilibriumHelps to find out leakages in the circular flow in the form of savings, taxes and imports and their effects on income and expenditureHighlights the importance of monetary & fiscal policies to bring about equality between income and expenditureHelps to understand a typical pattern : Production creates income, income creates spending and spending induces production. Thus there are three ways by which size of circular flow can be measured: At the production stage by the value of output, at the income stage by the amount of factor incomes earned and at the spending stage by the amount of total expenditure in the economy. So all the three can be used for measuring national income of an economy

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