Circular Flow CAPS requirements The open economy circular

Circular Flow

CAPS requirements • • 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

The participants in an open circular flow model

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

The markets in an open circular flow model

Factor market HOUSEHOLDS (FOP) (land, labour, capital, ent. ) FIRMS (income) (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, production and income flows SPENDING FLOW INCOME FLOW PRODUCTION FLOW Spending on goods and services (TS) = what is (TS) = being produced (TP) = what is and paid out as to Total undertaken by households (TP) = interest Rent, spending wages/salaries, profits Consists of consumer goods/services and capital (consumption) and firmsin(investment). income (TI) to FOP used production. (TI) from households firms. goods. TS = C + I

S isspending a leakage C =TS 800 =in. TP IYthe is==an 1 model TI 000 injection The total is equal to: S ==Equilibrium YC–+CI =Y 1800 =000 1 000 – 200 800 S= =1 I 200 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 = TP = TI Total injections Total leakages TS =Yd IIYS+++–G GTTC====200 900 + 200 + 100 = 1 200 Equilibrium since S + T = I + G SC=+=Yd 1 200 – 50 = 1 150 – 900 = 250 Y = 1200 250++100 50 ==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 + =I=+=Yd (X M) Injections X Leakages SYd TP =G Y=S–I=+++CTTI TG+–+M = 200 + 100 = 400 = 230 + 50 + 120= 400 = 1 130 – 50 = 1 080 – 850 = 230 Y = 1 130 = 850 + 200 + 100 + (100 – 120) = 1 130

National account aggregates and conversions 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

Production method: Gross domestic product (GDP): total value of final goods and services produced within the country in a given period.

What is the total value added of these four transactions? • A farmer produces 1000 bags of wheat which he sells to a miller at R 10 per bag, yielding a total of R 10 000. • The miller processes the wheat into flour, which he then sells to a baker for R 12 500. • After baking bread with the flour, the baker sells it to a shop for R 18 000. • The shop subsequently sells the bread to final consumers for R 21 000.

R 61 500

Must differentiate between final and intermediate goods – avoids double counting.

Expenditure method: Gross domestic expenditure (GDE): total value of spending on final goods and services within the borders of a country. GDE = C + I + G

Income method: 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.

Factor Prices (cost), Basic Prices and Market Prices

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

Factor Prices (cost), Basic Prices and Market Prices

Do all methods give the same answer? • Farmer to miller for R 50 • Miller to Baker for R 100 • Baker to Consumer for R 150 Expenditure method = Expenditure method R 150 • Value of final output Production (value added method) = R 50 + R 50 = Production R 150 Income method = R 50 + R 50 = R 150 • Value added = income earned by FOP

Summary…

The multiplier: an initial change in spending changes the level of output and income by more than the initial change in spending.

4. Firms increase production by R 800. 6. Final increase in total spending, production andgoods income = 1. R 1000 investment (buy capital 8. Multiplier = 1 2. Total production 5. Increase in C of R 640 (80% × R 800 ). 3. Households save 20% (marginal propensity to save) save 20% R 2 962 More FOPincrease employed – household income increases by The multiplier in the circular flow model Further in production and income of R 640. Spend 80% (marginal propensity to consume) Spend 80% increases by(RR 1 000 increase 000 1 – +R 1 0, 8 = 5 in income. from local 1 000 + R 800 + R firm) 640 R 512) R 800.

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 Aggregate Expenditure Model (I)In = income earned by households AE = Y Income (Y)

When AE < Y inventories accumulate AE < Y When AE > Y inventories fall AE = Y Y 2 Y Y 1

Example: I Example: increases by R 5 mill Example: I increases bymill R 5=mill Example: MPC Y increases = 0. 75 ∴ by multiplier R 20 4 MPC = 0. 75 ∴multiplier = 4

ANSWER = 120 MPC = 0. 75 What is the new level of Y? Y

What is the multiplier? Multiplier = 10 MPS = 0, 1 What is the MPS?

MPS =0. 2 AE increased 4 How much did AE go up by?