Module 13

The circular flow of income

Start of short run theory of income determination. explains relation between actual
and potential output at a given point in time assuming technical knowledge is not
changing and production frontier is fixed. Therefore this is only short time. It
explains why society reached or not production frontier but doesnt explain much
economic growth,.
Since that technical knowledges fixed output can only be altered by employment.
Levels.
Short run theory of income determination level of actual income is determined by
aggregate demand. Total income depend on demand since it affect employment.
Relation between aggregate demand and aggregate supply determines whether
society experiences;
unemployment and fails to realize production potential
full employment and capacity output
over full employment and rising prices.

13.2 The structure of the Economy A Two Sector

Model
Transaction between 2 groups household and firms.
Households consume goods and own resource (labour, land , capital)
Firms hire resources and produce goods.
(But also household form firms and firms produce/consume between them.)
Therefore there are 2 markets;
(a) the markets for goods and services that producers buy from households; and
(b) the markets for goods and services that producers sell to households.

133.2.1 National Income Accounting

National output is all final goods and services within a period ( usually 1 year)
Net National product = max consumption level that doesnt lower future
consumption ( i.e. leaves enough investment to offset depreciation)
Gross nation product = all economic output.

GNP depreciation= NNP

GNP is calculate by placing value ( price) on output. Only final products are included
since intermediary ones are used up to produce final product.
GNP can be calculated in three different ways:
(a) by finding the expenditure on final goods and services;
(b) by finding the value added by each producer; or
(c) by finding the total income earned by each factor of production.
GNE Gross Nation expenditures is total amount spent by households( and gov/firm acting
on their behalf). It is difficult to exclude intermediary product , i.e. that are not used up in
production of other products.

Steel purchased by car companies and car purchase by hire-companies are ignore.
Only household expenditure on cards and hire services is included.
Value added by producers = output minus inputs. GNP would be equal to sum of
this. ( inputs are therefore intermediary )

GNP is same as GPE and there it is not necessary to different between expenditures
done by firms or households.
Income is derived from value added at each level of production which eventually
accrues as factor income to same household.
Therefore
Gross national income = gross national product = gross national expenditure.
Primary factors of production ( inputs) labour, land, capital, enterprise.
(( Intermediate goods are NOT.)) they are not produced in current periods.
Income paid to owner of primary factors are;
Wages and salaries
Rent
Interest ( to household who loaned money)
Gross profits to entrepreneurs after all intermediary goods, wages, rents and
interest are paid.

Or

GNP = sum of producers value added = producers payment to primary

factors of product= Gross national Income= Gross national expenditure.

13.3 The equilibrium level of National Income.

National income can be measure by
Sum of expenditures
Sum of outputs ( value added)
Some of factor incomes
Since profits are residual all factor incomes must equal the value of national
output
IE. All output must accrue as income to some household. \
IE all income enjoyed by community is determined by flow of final products.
This creates the circular flow model at each production process value added will
accrue as income to some household.
Also it follows that income received must be sufficient to purchase all output.
Business create product this very process creates an accrued income equivalent to
value of product. However business will also sell if the increase income translates
into effective demand and actual expenditure.
Actual level of output is dependent on level of expenditure and effective demand.
Potential (capacity) output sets limit of output ( income) of a community but actual
output may fall short.
In short run actual output diverges from capacity output.
Short run theory see that level of actual income/output depend on level of
aggregate demand , with capacity output setting limit to real income and output.
Simple model of circular flow assumptions;
Fixed technical knowledge and labour so potential output is fixed
Fixed relation between output ( income) and employment both move in
same direction
No international trade
No gov or taxes
All savings done b households ( no retained profits by firms)
All investment done by firms
All prices are constants - so any change to nation income Y is cost of change
in real national income which is equal to output of final products.

Imp definitions

Consumption C = expenditure on products that satisfy current need

Savings S = income not spend on consumption
Income Y = C + s
Investments I = product of goods that are not used for consumption . 2 types
( inventories ie invest in future product. Level changes can be planned ( eg
increase production) or unintended by error in forecasting). ( capital goods
this affect productive capacity. Either to compensate for deprecation or
increase net volume of capital goods).

Gross investment I = replacement investment and net investment.

As a concept gross investment is used and gross national product is used
because expenditure on replacement investment if part of effective
demand since it creates labour.

13.4 The savings investments Schedule

Gross national product Y = all consumption now C and goods for later consumption
I
National Income Y = purchase of consumption C and savings for future
consumption. S
Therefore at equilibrium S = I .

13.5 The concept of equilibrium

Simple model of circular flow on income between 2 players H households and films.
While actual savings = actual investments, planned savings and investments are
only equal when equilibrium nation income is established.
IF we suppose that all income is consumed then;
All value added accrues as income
All incomes is used to purchase products.

Therefore supply creates its own demand. No injections into the circular flow and no
changes in level of income , equilibrium.
In reality if all is consumed and no investments there would be loss of future income
due to deprecating capital.
Savings are withdrawn from circular flow they do not generate demand, income or
employment. There is a contractionary effect on level of national income.

Investments are injected into flow this is part of aggregate demand

( expenditure) , creates demand for output and results income and employment.
There is an expansionary effect on level of national income.
Therefore equilibrium only when planned savings ( by households) and planned
investments ( by firms) are same. If not national income is not in equilibrium and
must change until equality of sav/invs plans is achieved.

If savings are increased beyond equilibrium level -> aggregate demand will fall ->
unplanned increase in inventories. -> firms react by reducing output .
The new equilibrium will be some multiple of initial increase in planned savings.
National income keeps decreasing until percentage savings equals percentage
investment. If savings double and investments remain same then national income
halves.
In example below investment is fixed at 10 and savings from a 10% went up to
20%. Income will go down until 20% of national income = 10 , same as investment.