TOPIC 1
CIRCULAR FLOW
The Circular Flow Model
•
The open-economy
•
National account aggregates and conversions
•
The multiplier
Interpret the Open Four Sector Circular-Flow
Diagram
Interpret the Open Four Sector Circular-Flow
Diagram
Households are the
primary participants
in the economy,
because they own
and control the
factors of production
and are the
consumers of goods
and services
Interpret the Open Four Sector Circular-Flow
Diagram
Firms are the
businesses who
produce the goods and
services. Firms
purchase the factors of
production from
households.
Interpret the Open Four Sector Circular-Flow
Diagram
Government is the public sector who produces merit goods and supplies this
to households and firms and purchases products from firms and provide
them where it is needed
Interpret the Open Four Sector Circular-Flow
Diagram
Financial sector
consists of all
financial
institutions that
act as a link
between
households and
businesses for
savings and
investments
Interpret the Open Four Sector Circular-Flow
Diagram
All the households,
businesses and
public sectors
outside the borders
of the country with
which we transact
Interpret the Open Four Sector Circular-Flow
Diagram
Real Flow:
Flow of goods and
services from Firms
to Households
Money Flow:
Factor income for
the payment of the
use of the factors of
production from
Firms to Households
Money Flow:
Payment received
for goods and
services consumed
from Households to
Firms
Real Flow:
Flow of the factors
of production from
Households to Firms
Justify the equality of L = J
Leakages
• Savings
• Taxes
• Imports
Injections
• Investments
• Government Expenditure
• Exports
J=L
•
There is an indirect link between savings and investments, taxes and
government expenditure and imports and exports.
•
If more money is saved in banks, more money is available as loans for
investments
•
If income from taxes increases, the government will be inclined to increase
expenditure.
•
If imports increase, foreigners’ income will increase and as a result, they will
be able to purchase more of a country’s exports.
•
These links do not guarantee that savings will equal investments etc.
•
Decisions to save and invest are taken by different groups and therefore these
amounts may differ vastly.
Explanation of an economy in Equilibrium
The total value of income (Y) will be equal
to the value of consumer spending (C) plus
government spending (G) plus investments
(I) plus the value of exports (X) less the
value of imports (I)
Y = C + G + I + (X – M)
Since the level of income in a country is
also equal to GDP, we can re-write:
GDP = C + G + I + (X –M)
When is an Economy in Equilibrium?
•
When households spend all of the money they earn
•
When businesses put all their profits back into producing more goods
and services
•
When production meets demand
•
When everyone earns enough money to purchase what they need.
When L = J, the economy is in equilibrium.
When L > J, the economy is shrinking - disequilibrium
When J > L, the economy is expanding - disequilibrium
Relate aggregate spending to income
Relate Aggregate Spending to Income and explain
Autonomous Consumption and Marginal Propensity to
Consume (mpc)
•
•
•
•
The amount of money which
households spend (C) is dependent
on their level of income
The mpc is defined as the proportion
of additional income which
households spend on consumption
The money households don’t spend
on consumption is saved, defined as
the proportion of additional income
saved (mps)
mps + mpc = 1
•
One component of consumption
spending is independent of income
•
The amount of money needed to
stay alive regardless of how much
they earn
•
The level of consumption spending
which is independent of income, is
known as autonomous consumption
•
C = Autonomous C + MPC x Y
Markets
•
•
A place where buyers and sellers meet and exchange goods, services and
money
Factor market
•
Where labour is hired
•
Entrepreneurial services are offered
•
Capital is borrowed
•
Property is rendered
Product market
•
Where businesses sell goods and services to households and public enterprises
Financial Market
•
Financial institutions act as agents to facilitate the lending and
borrowing of funds.
Money Market
• Market for short term savings and loans
• Less than a year
• SARB, Commercial Banks
Capital Market
• Market for long term savings and loans.
• More than a year
• JSE
Foreign Exchange Market
•
Households and firms require foreign currency in order to purchase
imports from the foreign sector.
•
Firms also use the foreign exchange market to exchange foreign currency
that they receive in return for their exports.
•
The price we pay for another currency is called the exchange rate.
•
Exchange rates are determined by the forces of demand and supply,
which is influenced by the volume of imports and exports.
National Account Aggregates
•
Calculate the total amount spent on goods and services produced by
households, firms, the government and foreign visitors to the country
•
Calculate the total amount earned by households as remuneration for
the factors of production.
•
Calculate the value of all final goods and services produced within a
country.
National Account Aggregates
•
Calculate the total amount spent on goods and services produced by
households, firms, the government and foreign visitors to the country
•
Calculate the total amount earned by households as remuneration for
the factors of production.
•
Calculate the value of all final goods and services produced within a
country.
One person’s expenditure is another
person’s income. The value of any good
produced, would be equal to the sum of the
remuneration received by those who own
the factors of production
Converting Domestic Production to National
Production (GDP to GNP)
•
GDP
•
•
Indicate production taking place
within the borders of a country
•
Does not matter whether production
is done by South Africans or South
African firms.
•
Value of all final goods and
services produced within the
borders of a country during a given
year.
GNP
•
Indicates output of a country,
produced by the factors of production
owned by the permanent residents of
that country, regardless of where
production takes place.
•
Value of all final goods and
services produced by the
permanent residents of a country
during a given year.
GDP + primary income from the rest of the world –
primary income to the rest of the world = GNP
Calculating Aggregate Production (GDP)
Income Method
• Adding up all the money earned by the factors of production
• GDP at factor cost (GDI)
Production Method
• Adding the value added at each stage of the production process
• GDP at basic prices (GVA)
Expenditure Method
• Adding up the money spent in the economy by households, firms, government (GDE)
• After adding and/or subtracting the transactions with the foreign sector we derive GDP
at market prices
Summary of the Methods used to calculate GDP
GDP (P)
GDP (I)
GDP (X)
Primary Sector
Compensation to employees
Final Consumption Expenditure
by Households (C)
+ Secondary Sector
+ Net operating surplus
Final Consumption Expenditure
by Government (G)
+ Tertiary Sector
+ Consumption of fixed capital
(provision for depreciation)
Gross Fixed Capital Formation
(I)
= Gross value added at factor
cost
+ Residual item
+ Taxes on production
- Subsidies on production
= Gross Domestic Expenditure
(GDE)
= Gross value added at basic
prices
= Gross value added at basic
prices
+ Exports (X)
Taxes on products
- Subsidies on products
+ Taxes on products
- Subsidies on products
- Imports (M)
= GDP at market Prices
= GDP at market prices
Expenditure on GDP at market
prices
WORKED EXAMPLE: GDP(P)
WORKED EXAMPLE: GDP(I)
WORKED EXAMPLE: GDP(E)
Converting Gross Domestic Product To Net
Domestic Product (GDP to NDP)
•
During production capital items,
like machinery and equipment,
depreciate and lose value.
•
The cost of production is not
taken into account.
•
The consumption of fixed capital
is the amount by which capital
goods depreciate during the year
•
Net Domestic Product measures
the value of production, once
adjustments have been made for
consumption of fixed capital.
•
GDP – consumption of fixed
capital = NDP
Converting Nominal GDP to Real GDP
•
Nominal GDP
•
•
The prices of goods during the period
•
GDP at current prices
Real GDP
•
The prices of goods adjusted for
inflation
•
GDP at constant prices
Nominal GDP x 100÷deflator
Explain the purpose of the System of Accounts
(SNA) as outlined by the UN
•
The System of National Accounts (SNA) is the internationally agreed standard set of
recommendations on how to compile measures of economic activity. The SNA describes
a coherent, consistent and integrated set of macroeconomic accounts in the context of a
set of internationally agreed concepts, definitions, classifications and accounting rules.
•
In addition, the SNA provides an overview of economic processes, recording how
production is distributed among consumers, businesses, government and foreign
nations. It shows how income originating in production, modified by taxes and
transfers, flows to these groups and how they allocate these flows to consumption,
saving and investment. Consequently, the national accounts are one of the building
blocks of macroeconomic statistics forming a basis for economic analysis and policy
formulation.
•
The SNA is intended for use by all countries, having been designed to accommodate the
needs of countries at different stages of economic development. It also provides an
overarching framework for standards in other domains of economic statistics,
facilitating the integration of these statistical systems to achieve consistency with the
national accounts.
The Multiplier
•
The multiplier is the process whereby an initial change in spending,
changes the level of output and income by more than the initial change
in spending.
2 Sector Model
•
In a closed economy with no public sector:
•
Aggregate Expenditure (E) = consumption spending by households (C) + investment
spending by businesses (I)
•
E=C+I
An Economy
in a state of
Equilibrium
Marginal Propensity to Consume and Marginal
Propensity to Save
•
mpc
•
•
•
•
Personal income is what is paid to
people as earnings before tax has
been deducted
Disposable income (Yd) refers to
personal income after tax has been
deducted
Consumption is the using of goods
and services to satisfy wants and
needs
Refers to the proportion of their
disposable personal income that
they spend on consumption, rather
than saving
•
mps
•
•
Saving refers to all of the disposable
income that is not spent on
consumption
The proportion of their disposable
income that households save is
known as the marginal propensity
to save
mpc = change in consumption (∆C)
change in disposable income (∆Yd)
The Multiplier process
•
The multiplier starts with an
injection into the spending of flow
R1 000
•
Production has increased by R1 000
•
Households earn R1 000 income for
production
•
Households save 20% of their
income
•
That means they increase their
consumption by R800
•
This process continues
Deriving the Multiplier
•
The multiplier is the number by which the change in the initial spending or
withdrawal must be multiplied to determine the resulting change in income of
an economy.
•
The multiplier is denoted by the symbol K
•
The extent of the effect of the multiplier will depend on the proportion of
people’s income that they spend.
•
K=
•
The larger the mpc, the larger the multiplier
•
The multiplier (K) and mpc have a direct relationship
•
The multiplier (K) and mps have an inverse relationship
1
1 −𝑚𝑝𝑐
or K =
1
𝑚𝑝𝑠
Apply the basic formula
•
If the mpc is 0,7, calculate the multiplier
Apply the basic formula
•
If the mpc is 0,7, calculate the multiplier
Apply the basic formula
•
If the national income increases by R200 million as a result of a R50
million investment, calculate the formula
Apply the basic formula
•
If the national income increases by R200 million as a result of a R50
million investment, calculate the multiplier.
K=
∆𝒀
∆𝑪
Graphic Illustration of the Multiplier Effect
•
Equilibrium is where E = Y
•
Initially, economy operates at
level E0 = C0 + I0
•
Income is thus at Y0
•
If the level of investments (I)
were to increase from I0 to I1, the
curve will shift to E1 and a new
equilibrium will be reached at Y1