Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 18
The Circular Flow of
Income and
Expenditure
•
The Basic Circular Flow of Income and
Expenditure
This figure shows the
circular flow of
income and
expenditure for the
simplest possible
economy.
• Production, carried
out by firms,
generates incomes for
households in the
form of wages,
interest, rents, and
profits.
• Households
immediately spend all
of their income on
consumption.
Measures of Production: GDP
 Gross Domestic Product (GDP) is the market value of
final goods and services produced within a country
during a specific time period, usually a year.
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Valued at Market Value
Only Final Goods and Services Count:
Sales at intermediate stages of production are not counted
as their value is embodied within the final-user good. Their
inclusion would result in double counting.
Excludes financial transactions and income transfers since
these do not reflect production.
Must be produced within the geographic boundaries of the
country.
Net additions to inventory are current period output so are
also included.
Measuring Output as Income: GDI
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Gross Domestic Income: GDI is the sum of the income
(including profits) received in producing final goods and services
during the period.
All of the payments made to producers are paid out to wageearners, business owners, governments, etc. Thus in total the
incomes must equal to the payments, which are equal in dollar
value to the total expenditures.
Payments include:
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Wages and benefits paid to workers,
Proprietors’ income,
rents,
interest,
corporate profits,
Indirect business taxes
Net factor income from abroad
Capital consumption allowance.
Definitions:
• Consumption: Purchases by
households for their own use.
• Closed Economy: An economy
with no links of trade or
finance with the rest of the
world.
Definitions:
• Tax Revenue: Total value of all taxes collected
by government
• Net Taxes: Tax Revenue minus transfer
payments
• Transfer Payments: Payments by government
to individuals NOT as payment for a current
period product or service.
– SSI, Pensions, unemployment, disability payments,
etc.
Leakages and Injections in a Closed Economy
• A closed economy is one that
has no links to the rest of the
world
• Leakages: Uses of income
other than consumption
– Net taxes (tax revenue minus
transfer payments)
– Saving
• Injections: Expenditures on
GDP other than consumption
– Government purchases of
goods and services
– Investment
Leakages and Injections in a Closed Economy
• Total leakages must equal
total injections (S+T=I+G)
• If the government budget
has a deficit, it must borrow
from financial markets
• If the government budget
has a surplus, the excess tax
revenue is used to repay
previous debt
An Open Economy
• An open economy is one with
links to the rest of the world
• One link is a new leakage, in
the form of payments made
by domestic residents for
imports from the rest of the
world
• A second link is a new
injection, payments made by
foreign residents for exports
from the domestic economy
• Total leakages must equal
total injections
T+S+Im=G+I+Ex
Financial Outflows
• If exports exceed imports,
the excess earnings from
sales of exports will result in
financial outflows to the rest
of the world
• These can take the form of
lending to foreign borrowers,
or purchases of foreign
assets by domestic investors
Financial inflows
• If imports exceed exports,
the excess imports must be
financed by financial inflows
from the rest of the world
– Borrowing from foreign banks
or other sources
– Purchases of domestic assets
by foreign investors
• The financial inflows can be
used to finance a
government budget deficit,
for foreign investment in the
private sector, or a
combination of the two
The Twin Deficit Syndrome (1)
• Total injections must
equal total leakages:
(G-T)+(I-S)+(Ex-Im)=0
• G-T is the government
deficit (positive if deficit)
• I-S is the difference
between investment and
saving (positive if
investment exceeds
saving)
• Ex-Im is the “trade
deficit” (net exports),
positive when there is a
trade surplus, negative
when there is a deficit.
When there is a trade
deficit, there must also
be a financial inflow
The Twin Deficit Syndrome (2)
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Early 1990s: Domestic
saving sufficient to
cover domestic
investment plus part of
the budget deficit, so
trade deficit was
moderate
Late 1990s: Budget
surplus helped partially
finance growing
investment, so trade
deficit remained
moderate
Mid 2000s: Large trade
deficit needed to
finance growing
investment and large
government deficit
Components of GDP
• The sum of all expenditures
on domestic goods and
services (consumption plus
all injections) must equal
GDP
• The basic equation for GDP:
Q = C + I + G + XN
( GDP = C + I +G + XN )
• We avoid double counting/
inappropriate counting by
subtracting imports from
total measured expenditures;
so XN = Exports - Imports
GDP = C + I +G + XN
• C = Consumption (household spending)
• I = Gross Private Domestic Investment
• Fixed Investment (real Capital Purchases)
• Inventory Investment (changes in inventory of finished
products, intermediate products, or raw materials)
• G = Government Purchases
• excludes transfer payments
• XN = Net Exports (Exports – Imports)
Planned Expenditure (Ep)
• Planned investment (Ip) consists of two
components:
fixed investment + unplanned inventory
investment
• Total planned expenditure is given by the
following equation:
Ep = C + Ip + G + XN
Determinants of Consumption
• Consumption depends, in
the first place, on
disposable income
• The amount of added
income devoted to
consumption is called the
marginal propensity to
consume
• Consumption that takes
place regardless of the level
of income is called
autonomous consumption
Other factors affecting
consumption:
• Consumer wealth
• The level of net taxes
• Interest rates
• Consumer confidence
Determinants of other expenditures
Planned investment
expenditure depends on
• Interest rates
• Business confidence
• Other elements of the
business climate in the
domestic economy and
abroad
• Government purchases are
considered to be
autonomous, that is,
determined by political
factors outside the
economic model
• Net exports depend on
– The level of domestic income
– Exchange rates
– Level of foreign income
Equilibrium in the Circular Flow
• The circular flow is said to
be in equilibrium when
total planned expenditures
equal GDP
• In that case, there will be no
unplanned inventory
investment
• If there is unplanned
inventory decrease, firms
respond by increasing
output and the circular flow
expands
• If there is unplanned
inventory increase, firms
respond by reducing output
and the circular flow
contracts
Injections
• For equilibrium to occur, leakages must be
offset by corresponding injections.
• Injections include investment, government
spending, and exports.
Leakages and Injections
Spending Multiplier
• The spending multiplier is a measure of the change
in equilibrium income (real GDP) produced by
change in autonomous expenditures (Spending that is
determined independent from income levels/GDP)
– By how many dollars does real GDP change for every dollar
change in autonomous expenditures?
1
1
Multiplier 
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leakages MPS  MPI
• MPS: marginal propensity to save
• MPI: marginal propensity to import
Marginal Propensities
• Marginal Propensity to Consume (MPC)
• Marginal Propensity to Save (MPS)
• Marginal Propensity to Import (MPI)
– Each of these is stated in a decimal as a share of 1.
(They are considered as a percentage of disposable income
generally assigned to each of category of income
disposition)
– For Example: MPS =0.2 means that 20% of disposable
income is saved in this economy.
Computing
the Spending Multiplier
1
1
Multiplier 

leakages MPS  MPI
If MPS = 0.30 and MPI is 0.10, then
MPS + MPI = 0.40 = 4/10.
1/0.40 = 1/(4/10) = 10/4 = 2.5
The multiplier is 2.5.
NOTE: The spending multiplier would be larger in a closed
economy because MPI would be zero.
Multiplier at Work
Gaps
GDP Gap
• GDP gap =
potential real GDP – actual real GDP
Recessionary Gap
Recessionary gap
– How much additional spending must occur to achieve potential
GDP (i.e., to create full employment)?
GDP gap
Recessionary gap 
spendingmultiplier