1-CIRCULAR FLOW, NATIONAL ACCOUNT
AGGREGATES AND MULTIPLIER
1.
Current open circular flow model
1.1 Concepts
ECONOMICS AS SUBJECT AREA:
A study of how individuals, businesses, governments and
other organisations choose to use scarce resources to
satisfy their numerous needs and wants in a manner that
is efficient and equitable.
MACROECONOMICS:
Macroeconomics is a study of the economy as a
whole.Seeks to identify strategic determinants of the levels
of
national
income,
output
and
expenditure.
Unemployment, general price level, inflation and balance
of payments.
CLOSED ECONOMY:
An economy that has no foreign sector. Particippants are
households, firms, government and the financial sector.
OPEN ECONOMY:
An economy that import from and export goods and
services to other countries (international trade). The
paprticipants are households, firms, government, financial
sector and the foreign sector.
ECONOMIC MODELS
A model is a simplified representation of the reality and
may be iin the form of words, an illustration (diagram),
graph or an equation.
CIRCULAR FLOW MODEL:
Shows how the economy works.
The relationship
between income and spending in the economy. It shows
how the participants in an economy interact with one
another.
REAL FLOWS:
Flow of goods and services between households,
businesses and firms, e.g. flow of goods and services from
firms to households, the flow of factors of production from
households to firms and the state, flow of public goods
and services from the state to households and firms.
MONEY FLOWS:
Flow of income and spending between households,
businesses and firms, e.g. households earn income from
selling factors of production to firms and the state,
government spending on goods and services, taxes paid
to government, money flow between the financial sector
and firms and households.
LEAKAGES (L = S + T + M)
The removal or withdrawal of money from the economy.
Savings (S), taxes payments (T), payments for imports
(M).
INJECTIONS (J = I + G + X)
Additional money or introduction of money into the
economy. Investments (I) government spending (G) and
revenue from exports (X).
ECONOMIC EQUITY
The economy is in equity where L = J
THE CIRCULAR FLOW
1.2 Participants:
•
Households:
Is basic unit of consumption in the economic
system and the primary economic participants
Own the factors of production (land, labour,
capital and entrepreneurial ability)
Sell factors of production on the factor market to
firms (e.g. labour or capital markets)
In exchange for the services rendered for factors
of production, households receive an income
(rent, wage, interest and profit)
Use income to buy consumer goods and services
on productmarkets to satisfy their wants
•
Business sector:
Is basic unit of production in the economy
Businesses use the purchased factors of
production to produce goods and services
needed by households
Firms buy factors of production on the factor
market and sells finished manufactured goods on
the product market
Their final aim is to maximize their profits
Their endeavour is to earn sufficient income to
meet their operating costs.
Their activities affect the volume and smoothness
of the real and money flos in the economy.
•
Government:
- Refers to local, provincial and national
government
- Includes all government workers (e.g. politicians
and civil servants) as well as state-owned
enterprises e.g. Eskom and Transnet
- State provides households and firms with public
goods and services e.g. defence, law and order,
health care, education and infrastructure
- Government participates in the economy by
purchasing factors of production from households
and by purchasing goods and services from firms
in the goods market (G)
- In return government receives revenue from
households (PAYE) and firms (company tax)
- Government regularly borrows from private sector
(businesses and individuals) and from abroad in
order to balance its budgets
•
Foreign sector:
- Serves as a source and destination for goods,
services, savings and loans
- SA imports mainly machines, equipment and
intermediate goods from abroad
- Exports
mainly
minerals,
primary
and
intermediate goods to the foreign sector
- Trade between ther foreign sector and
households and businesses takes place in the
foreign sector in the form of imports and exports
- Revenue earned from this process is foreign
exchange, which is needed to pay for imports.
The foreign exchange market is located in the
financial system.
PAGE 1
1.3 Four sector circular flow diagram
Injections (J):
• Investmens (I) – money spent by enterprises which
they borrow or obtain from various financial institutions
through past savings and loans or new issueing of
shares. Invest in property and plant or equipment.
• Government expenditure (G) – spends money on
goods and services to deliver social and economic
services and provide infrastructure e.g. roads,
hospitals and schools
• Export income (X) – when foreign residents buy our
exports of goods and services.
1.6 Model equations e.g. Y = C + I + G + (X – M).
Y = E = C + I + G + (X – M)
1.4 Real flows and money flows
•
•
•
•
Transactions take place in markets. Every market
transaction is a two-sided exchange – sales in terms of
goods and services and purchases in terms of money
Goods and services are sold on the product market;
factors of production sold on factor market –
constitutes real flow
Consumers earn income from the sale of the services
of their factors of production, used to purchase goods
and services sold by producers in the product market –
consumers’ income and expenditure constitute a
money flow
Private and public goods and services flows in the
opposite direction than flows of expenditure and
taxation
1.5 Leakages (L = S + T + M) and injections
(J = I + G + X)
-
Real and money flows not always smooth and without
interruptions – goods and services produced or
imported do not arrive promptly, become it is part of
inventories or stored somewhere in the system or
exported.
- Sometimes money leaks from the flow as a result of
savings and taxes – new money enters the flow when
businesses borrow money or earn revenue from
exports
- Financial system contains variety of markets such as
capital (long run), money (short term) and foreign
exchange market.
- Deposit-taking institutions (banks) and non-deposittaking institutions (insurance companies) act as
financial intermediaries in these markets, where
savings from consumers, producers and government
are made available as loans to others. SARB is
prominent.
Leakages (L):
• Only part of income received by participants will be
spent on products produced by domestic enterprises –
the remainder will be withdrawn or leak out:
• Savings (S) – income that participants choose not to
spend – put aside for future use – must be net savings
(savings less loans by households)
• Taxes (T) – direct and indirect – no choice – receive
benefits like transfer payments, cash allowances
known as a negative tax.
• Import expenditure
(M) – consume goods
manufactured
with
imported
components
–
expenditure flows abroad.
THE CIRCULAR FLOW
Where:
Y = National Income
C = Total consumption expenditure (durable / semidurable / non-durable goods / services)
I = Total Investment (Residential buildings / nonresidential buildings / other construction and land
improvements / tansport equipment / other machinery and
equipment / transport cost)
G = Total government expenditure / expenditure on goods
and services / expenditure on fixed capital / labour cost /
net income received from sales
X = Total exports
M = Total imports
FIG 1.3 Graphic presentation of equation
E=Y
X
E
X
P
E E1
N
D
I
T
U E
R
E
C+I+G+(X-M)1
= Total
expenditure
S
R
C+I+G+(X-M)
= aggregate
demand
45º
45º
0
Y
Y¹
INCOME (Y)
2. Markets (in circular flow context)
2.1 Product- and factor market:
Factor market:
• market where services of factors of production are
traded (labour is hired, capital is borrowed, property is
rented and entrepreneurs offer their services)
• These services earn wages, interest, rent and profits
respectively.
• Factor market inludes labour, property and financial
markets.
Goods market:
•
Thousands of markets for goods and services
called the product market.
PAGE 2
X
•
In economics, it is called aggregation. In
microeconomics, we investigate the different
markets individually.
2.2
Financial (money and capital)
• Funds in the financial markets (money and capital
market) are channelled from units/firms/savers with
excess funds, to units/firms experiencing a shortage of
funds.
• In SA the money market for short term and very short
term (3 year and less) savings and loans.
• It is not a physical market, but exists when parties
(consumers and producers) make demand and shortterm deposits and borrow on short term.
• In a more sophisticated form it exists when deposit and
non-deposit
intermediaries,
businesses
and
Corporation for Public Deposits engage in
communications that influence the prices of short-term
funds and include: bankers acceptances, short-term
company debentures, treasury bills, Reserve Bank
debentures and short-term government bonds.
• SARB as financial institution is key in the money
market.
• The capital market is a market for long term financial
instruments.
• In its simplest form it exists when consumers and
producers make long-term deposits and borrow on
long term such as a mortgage bond.
• It exists when deposit and non-deposit intermediaries
engage in communications that influence the prices of
long-term funds and long-term securities.
• JSE is a key institution in the capital market. Here
company shares and other debts that are listed are
traded.
2.3 Flows in the economy (production, income and
expenditure).
•
•
•
Flows of private and public goods and services are
real flows and they are accompanied by counter flows
of expenditure and taxes.
Factor services are real flows and they are
accompanied by counter flows of income.
Imports and exports are real flows and they are
accompanied by counter flows of expenditure and
revenue.
SPENDING AND INCOME
Savings
Financial
sector
Households
Savings
Business sector
Investment
SPENDING AND INCOME
Fig 1.2 Financial sector within the circular flow of income
and spending
2.3 Foreign exchange market:
• In an open economy foreign exchange is needed to
finance transactions between countries.
On the
international exchange market one country’s currency
is exchanged for another currency.
• Rands are exchanged for dollars.
The foreign
exchange market is multinational inscope. Leading
centres for foreign exchange dealings are London,
New York and Tokyo.
• In South Africa this all happens at banks.
• The SA rand is exchanged or traded freely in each of
these markiets and SARB has no control over it.
THE CIRCULAR FLOW
PAGE 3
3. Calculate national account aggregates and
conversions
•
The circular flow model is a macroeconomic mocel used to
study the economy. The model shows real and money
flows.
Wee need to measure these flows.
Macroeconomic measurement does for the economy what
private accounting does for an individual business.
There is THREE methods to measure the total economic
activity, i.e. production, income and expenditure methods.
3.1 Concepts: GDP and GNP, GDE, GDI
GDP is the total value of all final goods and services
produced within the borders of a country in a given year.
GNP is the value of all final goods and services produces
by the permanent residents in the country in a given year.
GDE measures total expenditure on final goods and
services produced within the borders of the country by the
four main participants in the circular flow mode
GDI is the value of the remuneration paid to all factors of
production in a given year.
3.2
Deriving national account aggregates:
Circular flow is a flow of income and expenditure – starting
with production provoked by wants.
3.2.1
Production:
• The production (output/added value method) is where
the GDP at market prices is calculated by adding the
final values of all goods and services produced within
the borders of the country. Intermediate inputs should
be subtracted from final outputs to find the value that
was added by each sector – otherwise calculation
would amount to double counting.
Table 1.1 Shows the value added through production in
the different sectors of the South African economy in
2018:
VALUE ADDED THROUGH PRODUCTION
2019
R (bn)
1. Primary sector
457
2. Secondary sector
909
3. Tertiary sector
2 975
4. Gross Value Added @ basic prices
4 341
4.1 Plus – tax on products
545
4.2 Minus – subsidies on products
13
5. Gross Domestic Product @ market price
4 873
Source: SARB Quarterly Bulletin (December 2019)
•
•
•
•
•
If the market prices would be added in each stage of
production, the final value of production would exceed
the actual value of production –double counting.
That is the reason why the value in each stage of
production is added.
By calculating the GDP using the production method,
basic prices are used. Basic prices represents the
amounts receivable by the producer in purchasing a
unit of a good of service minus any tax payable plus
any subsidy receivable.
By calculating the GDP using the expenditure
method, market prices are used. These are the
actual prices paid by consumers for goods and
services plus taxes less subsidies.
By calculating the GDP using the income method,
factor cost is used. Factor cost is the amount
THE CIRCULAR FLOW
received by the different factors of production, used in
the production process.
To convert basic prices to market prices, tax should be
added and subsidies subtracted.
3.2.2
•
Expenditure method:
In the expenditure approach the expenditure by all four
most important sectors are added:
Consumption expenditure by private households (C)
Investment spending by business sector – fixed capital
formation (I)
Public sector (G)
Foreign sector (X-M)
Table 1.3 Indicate the total expenditure on GDP at market
prices.
EXPENDITURE WITHIN BORDERS OF SA:
2019
1. Final consumption expenditure by households
2 921
2. Final consumption expenditure by government
1 037
3. Gross capital formation
874
4. Residual item
24
5. Gross Domestic Expenditure
4 856
6. Export of goods and services
1 458
7. Minus Imports of goods and services
1 441
8. Expenditure on GDP at market prices
4 873
Source: SARB Quarterly Bulletin (December 2019)
•
GDP(E) = C+G+I+(X-M)
•
Table 1.3 indicates that South Africa exported more
goods in 2019 than goods imported. It led to an
injection of R17 bn.
•
National figures (GNP) related to total income of
production by permanent residents of a country,
regardsless where the production takes place – South
Africa or abroad.
•
Domestic figures (GDP) related to total income of
production within the borders of a country, regardsless
by whom.
Table 1.4 shows the diversion from domestic totals to
national totals.
R(bn)
GDP @ MARKET PRICES
4 873
PLUS : Primary income from the rest of the world
97
MINUS : Primary income to the rest of the world
251
GNP @ MARKET PRICES
4 719
Source: SARB Quarterly bulletin (December 2019)
•
•
•
3.2.3
•
GDP measures the value of production before
provision for consumption of fixed capital has been
made.
Provision for consumption of fixed capital is the
depreciation of machinery, equipment and vehicles.
Net domestic product (NDP) measures the value of
production after consumption of fixed capital
(depreciation) is taken into account.
Income method:
GDP(I) at market prices is calculated by adding all
income earned by the factors of production within the
borders of the country.
PAGE 4
Table 1.2 Indicates the gross domestic income of the
South African economy for 2019.
INCOME RECEIVED BY FACTORS OF
2019
PRODUCTION R(bn)
1. Compensation of employees
2 320
2. Net operating surplus
1 249
3. Consumption of fixed capital
676
4. Gross Value added at factor cost
4 246
5. Other taxes on production
102
6. Minus other subsidies on production
8
7. Gross Value Added at basic prices
4 340
8. Tax on products
546
9. Minus Subsidies on products
13
10 Gross Domestic Product at market price
4 873
Bron: Source: SARB Quarterly bulletin (December 2019)
•
•
Consumption of employees consists mainly of
gross salaries and wages earned by labour.
Net operating surplus includes mainly the total
value of goods and services that are produced less
costs. Costs consist of cost of intermediate goods
and services, cost of remuneration of employees,
cost of consumption of fixed capital. Shows the
profits and surpluses of enterprises before taxation.
3.3 National account conversions:
3.3.1
Basic prices
Some indirect taxes and subsidies are the reason that
certain goods and services enter our national account
statements at basic prices. This is because the amounts
that are added in the different sectors listed in the table
include taxes on production and exclude other subsidies
on production.
Taxes on production (payroll taxes,
recurring taxes on land, buildings or other structures, and
business and other licences).
Other subsidies on
production include employment subsidies and subsidies
paid to prevent pollution.
3.3.2
Factor cost
Use GDP at basic prices less taxes plus subsidies to
determine GDP at factor cost.
3.3.3
Market prices
Different kinds of indirect taxes and subsidies other than
those used above are used for the conversion of basic
prices to market prices.Taxes on products (VAT, taxes
and duties on imports and exports) are added, and
subsidies on products such as direct subsidies payable
per unit exported and product-linked subsidies on roducts
used domestically are subtracted. Taxes on production
are included (PAYE) and subsidies are excluded
(pollution) – related to production process and not to
individual products.
3.3.4 Net figures – net operating surplus after tax surplus.
Net fixed capital formation after consumption of tixed
capital. Net exports after deduction of imports.
3.3.5 National and domestic figures – national relates to
the aggregated iincome or production by the citizens of the
country wherever they may be economically active, locally
or abroad. Dommmestic relates to the aggregated income
or production produced within the borders of South Africa
by South African and foreign citizens.
THE CIRCULAR FLOW
PAGE 5
THE MULTIPLIER
Where k is the multiplier
4.1 DEFINITION:
(a)
•
•
•
•
We know that Y= C+I+G+X-Z, ie. (Y) is a function of C,
I, G, X and Z.
Any increase or decrease in C, I , G, X or Z will lead to
a corresponding increase or decrease in Y
General Explanation
The multiplier describes a situation where a change in
spending eg investment ultimately changes output
and income by more than the initial change in
investment income.
One person’s spending becomes the income of
another, which in turn becomes their spending. This is
income for another and so on.
•
The basic assumption of the multiplier is that the
economy starts of with unused resources (ie. there is
unemployment and firms are producing below
capacity)
•
When there is an increase in investment, new jobs are
created. These people now have income to buy goods
and services which increases demand. This results in
higher production which creates more job, raising
incomes further and increasing demand.
The initial change in investment spending results from
a change in real interest rates.
This multiplier effect effectively means that any change
in injection will lead to a larger change in GDP.
The multiplier also works in the opposite direction ie.
A decrease in spending will lead to a larger decrease
in GDP.
The initial change in spending is usually associated
with investment spending because of investments
volatility.
But changes in consumption, net exports and
government expenditure also lead to multiplier effect.
•
•
•
•
•
If mpc is 0.8, then mps is 0,2. Total is 0.8+ 0.2 = 1
Therefore k = 1
=
1 – mpc
1
=
1 – 0.8
1
= 5
0.2
1. With an investment of R1000 and the mpc being O,8
then the multiplier will be 5. Therefore the change in
total income will be 5 x 1000 = R5000.
2. The formula for multiplier will change according to the
type of the economy.
3. In a THREE sector economy which includes the state,
the marginal rate of tax has to be considered.
4. In a FOUR sector economy which includes the foreign
sector, the marginal propensity to import has to be
considered..
5. Therefore leakages like savings, taxes and imports
reduces the value of the multiplier.
Multiplier and the mpc
•
•
•
•
•
•
K
To calculate the multiplier we need to know a person’s
marginal propensity to consume (mpc).
The mpc tells us how much a person consumes for
every additional income earned.
The eventual change in income will depend on the
mpc.
The larger the mpc the greater is the multiplier
hence the higher the change in income.
mps + mpc = 1 (if the mpc is 75%(0.75), The mps will
be 25% (0.25).
The value of the multiplier is determined using the
following formula.
=
▲Y
▲J
or
1
1-mpc
THE CIRCULAR FLOW
or
1
mps
PAGE 6
Aggregate Expenditure
Graphical representation
E=Y
AE2= 20m + 0.6 (y)
45
E2
40
P
O
N
Q
AE1 = 10m + 0.6Y
36
L
M
30
20
E1
10
45◦
0
Total income (R millions) (Y)
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
The 45◦ line shows all levels where AE (Aggregate Expenditure) = Y (Income)
It represent equilibrium points where all leakages = injections
The assumption is that there are TWO participants (Households and firms)
The economy is in equilibrium at point E1.
The autonomous consumption for AE1 is 10m and the mpc is 0.6.
The multiplier is.2.5. [1 divided by 0.4 (mps) ]
An increase in I (R10 million) will move the consumption function to AE2
The new equilibrium position is at E2 where Y = R45m. (2.5 x 10m).
Increase in investment spending of R10m causes AE to increase to 20m.
Production and therefore income increases due to excess demand. (L to M)
Spending will increase by 6m (because of mpc) which increases production and income further.
This process continues until E=Y at E2 where income is R45m
At this point there is no need to increase production.
A change in I of R10m has resulted in a change in income of R25m. (R45m – R20m)
The above explanation of the multiplier is based on simplifying
assumptions. i.e. Consumption of domestic output rises by the increase
in income minus the increases in saving. In reality consumption increases by a
lesser amount than is implied by the mps. In addition to savings money is spent on
imports and taxes. This reduces the amount available for consumption spending.
Therefore the multiplier effect is reduced.
THE CIRCULAR FLOW
PAGE 7