Syllabus A1A: Explain determination of macroeconomic phenomena, including equilibrium national income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

The study of economics can be divided into:

  1. Macroeconomics

    Macroeconomics is the branch of economics that deals with the structure, performance, behavior, and decision-making of the whole, or aggregate, economy. The two main areas of macroeconomic research are long-term economic growth and shorter-term business cycles. It looks at “aggregate” behaviour, basically the sum of individual economic decisions.

  2. Microeconomics

    Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. It is the study of the individual’s (and firms) economic behaviour.

Macro-economic policy / macroeconomics

covers the following issues:

  1. Unemployment
  2. Inflation
  3. Productivity
  4. Interest rates
  5. Government budget
  6. Foreign trade (Imports v Exports)

National Income

is basically total Income earned.

In other words, the value of goods and services produced in a year.

  • NB: In the Exam!The terms National Income, GDP and GNP are used interchangeably.

Growth in National Income

National Income can increase due to:

  1. An increase in Aggregate Demand (AD) – the Demand curve moves to the right
  2. An increase in Aggregate Supply (AS) – the Supply curve moves to the right

How can Aggregate Supply be increased?

  1. Increased investment in technology
  2. Improvements in training
  3. Increased incentive for firms to employ workers
  4. Decrease in costs of goods to supply

The circular flow of income

  • Firms/ Companies pay their workers: – so people get INCOME
  • Firms make goods and people SPEND on those goods
  • This is the CIRCULAR FLOW of income / expenditure

What is the Circular Flow Model?

The circular flow model is an economic model that presents how money, goods, and services move between sectors in an economic system.

The flows of money between the sectors are also tracked to measure a country’s national income or Gross Domestic Product (GDP), so the model is also known as the circular flow of income.

Circular Flow Model

Summary

The circular flow model, also known as the circular flow of income, describes how money and economic resources flow in cycles between different sectors in an economic system.

In the basic (two-factor) circular flow model, money flows from households to businesses as consumer expenditures in exchange for goods and services produced by the businesses, then flows back from businesses to households for the labour that individuals provide.

The five-sector model consists of :

  1. households (the public sector),
  2. businesses,
  3. government,
  4. the foreign sector, and
  5. the financial sector.

Understanding the Circular Flow Model

The idea of circular flow was first introduced by economist Richard Cantillon in the 18th century and then progressively developed by Quesnay, Marx, Keynes, and many other economists. It is one of the most basic concepts in macroeconomics.

How an economy runs can be simplified as two cycles flowing in opposite directions.

  1. One is goods and services flowing from businesses to individuals, and individuals provide resources for production (labor force) back to the businesses.
  2.  In the other direction, money flows from individuals to businesses as consumer expenditures on goods and services and flows back to individuals as personal income (wages, dividends, etc.) for the labor force provided. This is the most basic circular flow model of an economy. In reality, there are more parties participating in a more complex structure of circular flows.

Circular Flow Models with Sectors

Two-Sector Model

The model described above is the two-sector model, which is the most basic model containing only two sectors: individuals or households and businesses. In the two-sector model, it is assumed that households spend all their incomes as consumer expenditures and purchase the goods and services produced by businesses. Thus, there are no taxes, savings, or investments that are associated with other sectors.

Three-Sector Model

In the three-sector model, the government is added to the two-sector model. In this model, money flows from households and businesses to the government in the form of taxes. The government pays back in the form of government expenditures through subsidies, benefit programs, public services, etc.

Four-Sector Model

The four-sector model contains the foreign sector, which is also known as the overseas sector or external sector. The overseas sector turns a closed economy into an open economy. It is connected to the other sectors through two flows of money:

  1. foreign trade (imports and exports) and
  2. foreign exchange (inflow and outflow of capital). Like the other sectors, each flow of money is paired with a flow of a factor of production or goods and services.

Five-Sector Model

The fifth sector – the financial sector – is added to complete the circular flow model. It includes banks and other institutions that provide borrowing and lending services to the other sectors.

Savings and investments are assumed in the five-sector model, which flow from other sectors with residual cash into the financial institutions, then out to the sectors that need money. As long as lending (injection) is equal to borrowing (leakage), the circular flow reaches an equilibrium and can continue forever.

Implications of the Circular Flow Model

As a fundamental concept of macroeconomics, the circular flow model has been widely applied in different studies, with significant impacts on the understanding of economics. Four examples are listed below to show the significance of the model.

  1. Measurement of national income: The sectors in the circular flow model are the components of the calculation of national income. The expenditure approach calculates a nation’s GDP as the sum of the household consumption expenditures, private domestic investment, government consumption and investment expenditures, and net exports (GDP = C + I + G + [X-M]).
  2. Knowledge of interdependence: The circular flow model underpins the knowledge of interdependence between sectors in an economic system. The activities and money flows cannot take place without interaction with another sector.
  3. Unending nature of economic activities: Money and economic resources flow in cycles indefinitely with an equilibrium of aggregate income and expenditures.
  4. Injections and leakages: The circular flow of an economy is balanced when the total injections equal the leakages. If injections overweight leakages, the country’s national income will grow. If injections are below leakages, the national income will decrease.

In Summary, INJECTIONS increase the Circular Flow

These are:

  1. Exports (More money coming from abroad) (X)
  2. Government Spending (helps firms and people spend more) (G)
  3. Investments (I)

WITHDRAWALS decrease the Circular Flow

These are:

  1. Imports (Money leaving for abroad) (M)
  2. Savings (money not being spent) (S)
  3. Tax (Money not being spent) (T)

Aggregate Demand (AD) is made up of

  1. Consumer Spending (C) – (See below)
  2. Injections:

    – Government spending (G)
    – Investments (I)
    – Exports (E)

  3. LESS:

    Imports (M)

Remember!

  • AD = C + G + I + (E – M) as in the summary above

Consumer Spending

Households (people) purchase goods and services using income from e.g. employment or rent of land or profits from running companies.

The amount households plan to spend is called Consumer spending

It has 2 elements:

  1. Income induced

    = we spend more as income rises

    Marginal propensity to consume (MPC) is a measure of the proportion of extra income that is spent on consumer goods.

  2. Autonomous consumption (a)

    – Is not dependent upon the current level of income
    – We will always spend it, doesn’t matter what

Formula for Consumer Spending

C = a + bY

  • Where:
    a = autonomous consumption
    b = the marginal propensity to consume
    Y = national Income
 

Example

Autonomous consumer spending = $300
Marginal propensity to consume = 0.3
National Income = $1,000

Required:

Calculate the Consumer Spending

  • Solution

    C = a + bY
    C = $300 + 0.3 x $1,000
    C = $600

Equilibrium condition

The economy will be stable where national income (Y) shows no tendency to change through time = Equilibrium

This is when planned expenditure (ie demand) equals national income (ie supply).

Therefore, where:

Exam Style question

Autonomous consumer spending = $100m
Marginal propensity to consume (MPC) = 0.4

Required:

Using the Formula C = a + bY for consumer spending and E = Y for equilibrium, calculate the equilibrium level of national income.

  • Solution

    Y = E at equilibrium

    So, National Income (Y) = Consumer spending (C)

    Y = C (which is a + bY)
    So Y = a + bY

    Y = $100 + 0.4Y
    0.6Y = $100
    Y = $167m

Now don’t forget C + Injections – Withdrawals = Y

 

Exercise:

Autonomous consumer spending = $100m
Marginal propensity to consume = 0.4
Injections = $300m

Required:

Using the Formula C = a + bY for consumer spending and E = Y for equilibrium, calculate the equilibrium level of national income.

  • Solution

    Y = E at equilibrium

    So, National Income (Y) = Consumer spending (C) + Injections
        
           Y = C (which is a + bY)
      So Y = a + bY + Injection

           Y = $100 + 0.4Y + $300
      0.6Y = $400
           Y = $433m

The Multiplier Effect

Imagine a consumer receives $100 more income – this will probably mean he/she spends more.

This means the firms get more income and supply more and thus pay more wages

So the consumer gets more wages and spend more again.

This is the multiplier effect

The effect of a $100m injection is to increase national income by a multiplicative effect of $140m / 100m = 1.4.

This 1.4 is called a multiplier.

A short cut to calculating the multiplier is to use this formula:

Exercise

Change in Injections = 100
MPC = 0.7

Required:

Calculate the following figures:

1) Value of Multiplier

2) Change in National Income

3) Change in Consumption

Solution:

  1. Value of Multiplier = 1 / (1 – 0.7) = 3.33
  2. Change in National Income = 100 x 3.33 = 333
  3. Change in Consumption = 333 – 100 = 233

Marginal Propensity to Withdraw (MPW)

This is easy

So if the MPC is 0.3 then the MPW is 0.7

Simple.

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