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The open economy circular flow model
The markets
National account aggregates and conversions
The multiplier:
– Definition of multiplier effect
– Explanation of the multiplier process aided with a
circular flow and examples
Households: owners of the factors of production.
• Households offer FOP to firms
• Firms use FOP to produce goods and services
• Households receive income(rent, wages and salaries,
interest and profit.) from firms in exchange for FOP.
• Households use this income to buys goods and services
in the goods market.
Firms: use factors of production to produce
good & services
Firms buy FOP’s from households in exchange
for income (rent, wages and salaries, interest &
profit).
Government: national, provincial and local
Gov. supplies goods/services to households and
also taxes households and firms.
Foreign sector: countries in the rest of the
world.
Important for imports and exports
Factor market
(land, labour, capital, ent.)
(salaries and wages, interest,
rent, profits)
Goods market
Firms sell goods/services to households, other firms and the
foreign sector.
Financial market
Money and capital markets.
Surplus funds deposited & loans are made in the financial market.
Real flows – flows of physical Money flows – aka nominal
things.
flows consist of the flow of
money.
Leakages: factors that cause a decline in the flow of spending, income and
production.
Savings (S), taxes (T) & imports (M).
Decreases the flow of money and the total spending in the economy.
Injections: factors that cause an increase in the flow of spending, income and
production.
Investment (I), government spending (G) & exports (X).
SPENDING
FLOW
INCOME
FLOW
Spending on goods
PRODUCTION
and services
FLOW
(TS) = what is
Total
being
spending
produced
undertaken
(TP) =interest
whatby
isand
households
paidprofits
out
asto
Rent,
wages/salaries,
Consists
of consumer
goods/services
and
capital
(consumption)
and
firmsin(investment).
income
(TI) to
FOP
used
production.
households
from
firms.
goods.
TS = C + I
S isspending
a leakage
C =TS
800
=inTP
IYthe
is==an
1model
TI000
injection
The total
is equal to:
S ==Equilibrium
YC–+CI =Y1800
=000
1 000
–200
800
S= =1 I200
TS
+since
000
From this three-sector circular flow
we can see that…
• Demand for goods/services in our economy
consists of C + I + G
• Flows of spending, production and income are
equal.
• 2 leakages: savings (S) and taxation (T).
• 2 injections: investment spending (I) and
government spending (G).
• In equilibrium leakages = injections (S + T = I +
G)
TS =injections
TP = TI
Total
Total
leakages
TS =Yd
IIYS++–
G
=
900
+
200
+
100
=
1
200
Equilibrium
SC=+=Yd
T
C
=
1
since
200
150
–
S
50
+
900
T
=
=
=
1
I
250
150
+
G
Y250
= 1200
+GT==200
++100
50 ==300
300
From this four-sector circular flow we
can see that…
• Demand for goods/services in our economy
consists of C + I + G + (X – M)
• Flows of spending, production and income are
equal.
• 3 leakages: savings (S) and taxation (T) and
imports (M).
• 3 injections: investment spending (I) and
government spending (G) and exports (X).
• In equilibrium leakages = injections
(S + T + M = I + G + X)
TS
= CTS
(X
M)
Injections
=S–I=+++CTTI
X
Leakages
S+Yd=I =+Yd
TP
=YG
TG+–+M
==200
++Y100
100
=400
400
==+230
11200
130
080
=––100
150
850
++130
120=
1 230
080
= 850
+50
+= =(100
– 120)
= 1 130
National accounts: accounting records of a country’s
total production, income and expenditure.
Calculated by using the circular flow model.
3 methods of calculating GDP…
1. production method – gross domestic product GDP(P)
or GDP
2. income method – gross domestic income GDP(I) or
GDI
3. expenditure method – gross domestic expenditure
GDP(E) or GDE
Gross domestic product (GDP): total value of
final goods and services produced within the
country in a given period.
• A farmer produces 1000 bags of wheat which
he sells to a miller at R10 per bag, yielding a
total of R10 000.
• The miller processes the wheat into flour,
which he then sells to a baker for R12 500.
• After baking bread with the flour, the baker
sells it to a shop for R18 000.
• The shop subsequently sells the bread to final
consumers for R21 000.
R61 500
Must differentiate between final and intermediate
goods – avoids double counting.
Gross domestic expenditure (GDE): total value
of spending on final goods and services within
the borders of a country.
GDE = C + I + G
Gross domestic income (GDI): measures income
earned by the FOP in the production of the GDP
of a country.
GDI measures income of all the people (citizens
and foreigners) within the borders of a country.
GNI measures income of all SA citizens even
outside the borders of SA.
Used when GDP is calculated according to factor
cost.
Differs from production approach because of taxes
and subsidies on production not reflected in the
factor prices.
Solution…
ADD taxes on production
SUBTRACT subsidies on production
= BASIC PRICES
Used when the GDP is calculated according to the production
approach.
Basic price differs from market price due to tax/subsidy on the
product.
Tax on products cause market price > basic price.
Subsidies on products cause basic price > market price.
Solution…
ADD taxes on product
SUBTRACT subsidies
= MARKET PRICES
• Farmer to miller for R50
• Miller to Baker for R100
• Baker to Consumer for R150
Expenditure method = R150
• Value of final output
Production (value added method) = R50 + R50 + R50 =
R150
Income method = = R50 + R50 + R50 = R150
• Value added = income earned by FOP
The multiplier: an initial change in spending
changes the level of output and income by
more than the initial change in spending.
4. Increase
Firms
increase
production
by
R800.
6.1.
Final
increase
in2.
total
production
andgoods
income
=
R1000
investment
(buy
capital
Total
production
5.
in
Cspending,
of
R640
(80%
×
R800
).
8.Multiplier
=
1
3.
Households
save
20%
(marginal
propensity
to
save)
R2 962
More
FOPincrease
employed
– household
income
increases
by
Further
in
production
and
income
of
R640.
Spend
80%
(marginal
propensity
to
consume)
increases by(RR11 000
000
increase
000
1 – +R1
0,8
= 5 in income.
from
local
+ R 800
+ R firm)
640
R512)
R800.
What is the marginal propensity to save in each
scenario, and what is its effect?
I.e. Amount spent by households (C) & Firms
Two
sector
equilibrium
economy:
(E);
CAE
+ I==CY(Y)
+I
(I)In
= income
earned
by
households
AE = Y
Income (Y)
When AE < Y inventories accumulate
When AE > Y inventories fall
AE = Y
Y2
Y
Y1
Example: I increases by R5 mill
Example:
I increases
bymill
R5= mill
Y
increases
by
R20
MPC
=
0.75
∴
multiplier
4
MPC = 0.75 ∴multiplier = 4
MPC = 0.75
What is the new level of Y?
ANSWER = 120
Y
Multiplier
= 10
What
is the multiplier?
MPS
= 0,1
What
is the
MPS?
MPS =0.2
AE increased 4
How much did AE go up by?