The circular flow of income: A model show how resources and products flow in exchange for money

Model with no leakages(savings, taxes, import) and injections (investment, government spending, export)

There is a flow in the clockwise

direction of factors of production
→ shows flow of money

National income(total income of a country)=national output=national expenditure

The circular flow of income model with leakages and injections

leakages injections
leakages>injection→ circular flow↓, national income↓
saving investment
leakages<injection→ circular flow↑, national income↑
taxes Government spending
Import spending Export spending

Measures of economic activity

Output approach Income approach Expenditure approach
Adding up the value of all final Sum of the factor incomes Sum of final expenditure within
goods and services produced happens to the economy the economy
within the economy
Wages+ Rent+ Interest+ Profit C+I+G+(X-M)
GDP GNP GNI
the market value of all final goods the market value of all final goods Total income earned by a nation’s
and services produced within a and services produced within a productive factors during a period
country over a period country over a period
Based on location Based on ownership
Border(국경) nationality
C+I+G+(X-M) GDP+ net income from abroad GDP + Net Flow Of Income
Shows size of an economy
GDP per capita: shows living standards in economy
total( GDP ,GNP , GNI)
=
number of population
Real GDP Nominal GDP
Exclude inflation Include inflation
Quantity Produced × 일정한 Prices Quantity Goods and Services Produced × Current
nominal GDP Price
×100
price index(GDP delator)

AD - A measure of economic activity

- Policy adjustment for policy-makers
- Policy evaluation for voters
Dis - Non-market output is not counted
- Black markets are not included
 - Quality improvement does not count(benefit↑, price↓)
- Reduced of natural resources does not count
- Negative externalities does not count
- Do not tell type of consumption of a country’s output
- Do not take into account differences in the price level between countries
- Do not tell distribution of income
- Do not tell about non-economic factors (happiness rate)
Green GDP: Measure of national income, with respect to environmental impacts
=GDP-environmental costs

Business cycle: periodic fluctuations in economic activity measured by changes in Real GDP
Recovery: Increase in AD, Unemployment↓
Potential GDP
Boom: increase interest rates
Recession: a significant decline in economic activity spread across the economy, lasting more
than a few months, normally visible in real GDP
Disinflation/deflation, GDP growths goes backwards, consumption&investment↓, AD↓,
unemployment↓
Trough: lower in interest rates, unemployment full
Potential output=full-employment=natural rate of output(maximum output
possible)
: the level of output unchanging with no pressure for the price level to rise or fall

Aggregate demand: amount of the total goods & services demanded in the economy, in a given time period
AD=C+G+I+(X-M)

Negative slope 이유:

- Wealth effort: higher price level→ wealth↓→ consumption↓→ less demand
- Interest rate effect: higher price level→ interest rate ↑→ investment&consumption↓→ demand↓
- International trade effect: higher domestic price level→ export↓import↑→ demand↓

Shift in AD
- change in consumption (consumer confidence, interest rates, wealth, income taxes, expectations of future price levels)
- change in investment spending (business confidence, interest rates, technology, business taxes, legal changes
- change in government spending (changes in political priorities, economic priorities: deliberate efforts to influence AD-
영향력을 행사하려는 의도적인 노력)
- change in X-M(changes in national income abroad(수출하는 나라 수입↑, 내 나라 AD↑), trade protection, exchange rates
Aggregate Supply: total amount of products that all industries in the economy will produce at a given level
SRAS: sticky wage, upward sloping: sticky wage

Shift in AS curve(short-term)
- change in wages
- raw material prices
- taxes↓
- trade union power↓
- unemployment benefits↓
Production cost
- raw material prices
- supply shocks
- change in import price
 LRAS: equilibrium level of output
Neo-classical
shift
- education & training
- R&D
- Provision of infrastructure
- Improved information
+ price level is not relevant
+직선인 이유(potential output 에서 직선임): Always produce at potential GDP(full employment)
 Wages and other factor prices change (no more sticky wages)→ only PL changes will under a given LRAS
+ SRAS curve will always return to LRAS curve
Keynesian

1. Low levels of activity, spare capacity is high, sticky wages

2. “spare capacity” is getting used up
3. No spare capacity, no increase in output
+Price level is relevant
+Intervention(개입)
+wages and product do not fall easily(sticky)(∴minimum wages laws, labor contracts, workers & union resist, morale issues)

 Inflationary gap
- Too much demand in the economy
- Huge demand on resources
- Employment increases
- Upward pressure on prices
- Output beyond the full employment level
↓ SRAS and AD shift same direction with LRAS

 Deflationary gap
- Not enough demand in the economy
- Not worthwhile to produce at capacity
- Unemployment less than natural rate

 Full-employment of output= natural rate of output= potential output

- Economy produce right amount of it
- Unemployment on the natural rate

Keynesian multiplier: Increase in injections will lead to a greater increase in national income
Helps to see the ripple effect a change in spending or saving has
MPC (Marginal Propensity to Consume): 소비에 사용할 의사가 있는 정도
change∈consumption
=
change∈income
MPW= MPS+ MPT+MPM=1-MPC
MPC+MPW=1
1 1 1
Multiplier= = =
1−MPC MPW MPS+ MRT + MPM
Real GDP=∆ injection ×multiplier
Real GDP= ∆ leakage × multiplier

Macro-economics objects
 Low unemployment
 Low and Stable rate of Inflation
 Economic Growth
 Equity in the distribution of Income

Unemployment: people who are able to work and willing to work, but jobless
number of people unemployed
= ×100
total labor force(emplyed +unemployed)

Difficulties to measure the unemployment

- Hidden unemployment (people who give up finding work)
- Underemployment: people with a part-time job who want a full-time job
- Ignores regional, ethic, age, and gender disparities are not taken into account

Economic costs - Fall in GDP

- Decreases tax revenue
- Under-utilization of resources
Personal costs - Decreased household income

Society costs - Decreased household income

- Increased stress&depression
 - Homelessness increase

Type of unemployment
종류 Cyclical unemployment Frictional unemployment Seasonal unemployment Structural unemployment
정의 cause by fall in GDP When people are moving Demand for a particular mismatch of the skills that
from one job to another labor by change in season required for existing job wants
원인 Decrease in AD Imbalance information between workers&employers changes in the structure of the
economy(demand for particular
labor skills, geographical location,
labor market rigidities)
분류 Involuntary Voluntary Predictable, voluntary Involuntary
long/short-term relatively short-term relatively short-term long-term
예시 During deep depression Search for better job, graduated Farmers, lifeguards Changes in industrial structure of
student Korea
해결 - Increase AD - unemployment benefits↓ - education & training
방법 - Improving information flow to job seekers - reduce labor market flexibility
- unemployment benefits↓ - deregulation
- training&education
Inflation: general rise in the price level in an economy over a period time
Deflation: decrease in the general level of price in an economy

Disinflation: decrease in the rate of inflation

CPI(consumer price index): the price of a set basket of consumer goods(measurement of living cost for the average
household)

Total cost=cost 1× basket 1+ cost 2 ×basket 2 …

year total cost
CPI=
base year total cost
CPIyear 1−CPIyear 2
Inflation rate= ×100
CPIyear 1
Weighted price index: determining a fixed basket of goods and services(weight↑→effect of cost of basket↑)

Problems:
- Different rates of inflation for different income earners
- Different rates of inflation depending on regional or cultural factors
- Changes in consumption patterns due to consumer substitutions when relative prices change
- Change in consumption patterns due to introduction of new products
- Changes in product quality
- International comparisons
- Comparability over time
- Do not include foods and energy products

Core inflation: excludes the products which PL changes very frequently(ex: food, oil)
situation happening general PL

 Demand-pull inflation: increase in total demand for nation’s output(AD shift right)

 Cost-push inflation: Result of a negative supply shock(AS shift left)

- 인플레이션의 단점: wage rate↑→regulation↑→exchange rate↓

consequences(inflation)- lower savings

 - lower investment
- higher inequality
- less-competitive export

Consequences(deflation) - Delayed consumption

- higher inequality
- cyclical unemployment

Short-run Philips curve: a possible unemployment & inflation rate in the short-run
Shift outwards, resulting in stagflation
caused by a decrease in SRAS

Opposite direction with SRAS

Long-run Philips curve: all wages and prices in an economy are

flexible

Vertical at the full-employment

No trade-off between the unemployment rate& inflation rate in the long run

Economic Growth: Increase in a country’s real GDP over a time period

GDP year 2−GDPyear 1

economic growth∈GDP 2=
GDPyear 1
- reduction in unemployment & increases in productive efficiency move point inside the PPC to a point closer
to the PPC.
- increase in production possibilities caused by factors including increases in the productivity of resources→
outward PPC shifts.

- increase in potential output caused by including increases in the

productivity of resources→ rightward shift of the LRAS curve.

Quantity and quality of resources↑→production possibilities↑=potential

output↑=pote ntial growth=LR economic growth
Sources: Physical capital: more & better capital goods- buildings, technologies↑
Human capital: more & better capital- unlimited resources
Natural capital: improve quantity & quality- sustainable use of the ecosystem services they provide
Consequences
GDP
- Living standards: real GDP per capita, happiness rate¿
total population
- Unemployment: SR- cyclical↓, frictional&seasonal 없음/ structural 은 경제성장 있어도 변화 X
- Inflation: SR- AD↑→demand-pull inflation, LR- LRAS↑→demand-pull inflation
- Distribution(분배) income: income inequalities
- Net export: SR- Net export↓, increase in the demand for imports, little in exports
- Sustainability: environmental unsustainability

Equity in the distribution of income: income is distributed in a fair or just manner

Equality in the distribution of income: everybody has the same amount of income
- unequal ownership of factors of production→ market system inequitable distribution of income

Lorenz curve: inequality of income or wealth

 A
Gini coefficient=
A +B
Larger value, less equity (0 에 가까울수록 평등함)

Absolute poverty: income below than the amount of money necessary to meet basic needs
Relative poverty: compared with the median income(relativity poor)
Cause of poverty
- low incomes
- involuntary unemployment: cyclical or structural unemployment
- lack of human capital

Consequences of poverty
- Low living standards
- Lack of access to health care education (human capital)
- Increase in crime
The role of government in promoting equity-

1. Taxes
Indirect tax: imposed on the consumption of products (ex: value-added tax, goods and services tax)
Direct tax: the money that people pay directly (ex: income taxes)- used to redistribute income
Proportional tax: income paid as taxes is fixed as income increases. 계속 20% (indirect taxes-바람)

Progressive tax: taxes increase as income rises. %계속 상승, 수입 상승 (direct taxes)

Regressive tax: increase in tax as income decreases. %하락, 수입 상승 (indirect taxes-현실)

AD Correction the market failure(negative externalities)

Dis Disincentives→ AD & GDP↓

Welfare losses→ reduction in the social surplus

Marginal tax rate Average tax rate

Tax rate paid on extra income Proportion of income paid as tax
∆ tax tax paid
¿ ¿
∆ income total income
Tax= (income2-income1)×marginal tax rate+…

2. Transfer payments: money transferred from the government to individuals without the exchange of products
Ex) old-age pensions, unemployment benefits, child allowances
AD Protect of the socially weak, enhancing human capital→ higher productivity

Dis Disincentive→ higher unemployment→ lower GDP, opportunity cost, pressure on government budget

3. governments undertake expenditures to provide directly, or to subsidize, a lot of socially beneficial goods
and services (merit goods), thereby making them available to those on low incomes.

AD Correcting market failure(positive externalities)→higher productivity- less than normal resources

Dis Opportunity cost, pressure on government budget

Demand side policies

Revenue of the government

- Tax revenue
- Sales of goods and services
- Sales of government-owned enterprises: privation
Types of Government expenditures(정부지출)
- Current expenditures(Consumption): ex) salaries for government employees, spending for supplies and equipment for everyday
operations of the government, subsides, and interest payments on government debt
- Capital expenditures(Investment): ex) public investment on infrastructure
- Transfer payments: ex) money transferred from the government to individuals without the exchange of a products.
Government budget(정부예산): governmental plan of its expenditures and revenues over a specific time period
Balanced budget: Tax revenue=Government spending
Budget surplus(-): Tax>G.S
Budget deficit(+): Tax<G.S→ the government borrows from the public by issuing government bonds
Public debt: the external duty of the government and public sector agencies
Publice debt =∑ (G−T )
Fiscal policy: a government policy using government spending and taxation in order to affect AD

Expansionary fiscal policy: to close the recessionary gap

Keynesian model: New classical/monetarist model

- PL→, output↑ in the upward-sloping section - PL↑, output↑
- PL↑, output↑ in the upward-sloping section

Contractionary fiscal policy: to close a inflationary gap

Keynesion model New classical/monetarist model

- PL↓, output↓ in the upward-sloping section - PL↓, output↓

Automatic stabilizers: economic institutions that reduce fluctuations in the total output without direct
intervention by policymakers

Measures to promote equity

 Progressive taxation & transfer payments can serve as an automatic stabilizer→ promote equity in the income distribution
Business cycle diagram AD-AS model

Long-term economic growth

 government spending(directly)
Government expenditure on physical capital: infrastructure and R&D→ more, better capital goods
Government expenditure on human capital: education, training, health care→ higher quality of human capital
Providing incentives for firms to invest: tax cuts→ more investment in capital
 private investment(indirectly)
Fiscal policies reduce economic changes→ stable micro-economic environment→ quantity & quality of capital
AD Direct impact on AD and effectiveness in a deep recession
Targeting particular industries, by changing the composition of the government spending
Growth in potential output
Di Possible ineffectiveness tax cuts in a deep recession
Time delay- possibly the opposite of purpose
s Political considerations
Inability to tackle cost-push(supply-side) inflation
Crowding out
Crowding out: increase in AD caused by an increase in G might be offset - by decreases in C&I
Recessionary gap→ expansionary fiscal policy→ deficit (적자) spending→ government borrowing→ interest rate↑→ C↓& I↓→AD↓
Monetary policy: a policy by the central bank, aimed at changing money supply and interest rate in
order to control AD

Reverse rate↓
Discount rate↓
OMO- buy bonds
Ms↑(quantitative easing)→IR↓→I↑

Role of central Banks

 usually made responsible for interest rates and exchange rates- achieve macro-economics objectives
 Money supply
Goals
 Maximum employment
 Stable prices
 Moderate long-term interest rates
Interest rate= Return on saving= Opportunity cost of holding money= cost of borrowing
Demand for money
Nominal interest rate↑→ opportunity cost of holding money↑→ people hold less amount of money
Supply of Money
Quantity of money circulating in an economy is fixed by the central bank no matter interest rate→ vertical money supply curve
Determination of interest rate
Shifts in Ms curve causes changes in the interest rate

Easy monetary policy: close recessionary gap: AD↑

Keynesian model New classical

- PL→, output↑ - PL↑, output↑
- PL↑, output↑
Tight monetary policy: close inflationary gap: AD↓

Keynesian model New classical

- PL↓, output↓ - PL↓, output↓
- Sticky PL, output↓
AD  Faster
 Independence from politics
 No crowding out
Di  Time lags
 Possible ineffectiveness of EMP in a deep recession (Japan)
s
 Inability in cost-push(supply-side) inflation
 Not purpose on government policies: exchange rate

Inflation Targeting: maintaining prices at a certain level or within a specific range (by change in interest rate)
AD  Reduced inflation volatility
 Reduced inflationary impact of shocks
 Increased anchoring of inflation expectations
Dis  Restricted ability of the central bank to respond to financial crises or unforeseen events
 Poor outcomes in employment, exchange rate and ither macroeconomic variables beside inflation
 Instability in the event of large supply-side shocks
 Lack of support from the public

Supply-side Policies: Increasing potential output of economy

Aim: positively affecting the production side of an economy: shift LRAS right→ growth in potential output
Interventionist: (Short-term: AD, long term: LRAS)
1. Investment in Human capital
Education & training
- Obtain skills→ higher demand
- Keep do training and education through subsidies or free loans
- Subsidies to firms and provide on-the-job training
- Direct hiring by the government to provide on-the-job training
- Spreading information on job availability in various regions
- Government projects to create new jobs
New technology: government policies encouraging R&D: tax incentives and patents(독점권)
- Firms’ investment in R&D↑→Development of new technologies→ Increase in the quality of capital

2. Investment in Infrastructure:
- Government spending↑→SR: AD↑
- Increased and improved infrastructure
- More and better physical capital, higher labor productivity- potential output↑→LR:LRAS↑
3. Industrial polices
: encourage the development and growth of a sector of the economy
- Tax cuts
- Tax allowances: 일정 소득 이하는 세금을 내지 않는 것 Benefit: small and medium-sized enterprises
- Subside lending Infant industries

Market-based
1. Encouraging competition
- Privatization: government privates a business it owns and controls, it sells- becomes privately
- Deregulation: removing government controls or rules from a business or other activity
- Trade liberalization: the reduction or removal of the barriers on free trade between countries
- Antimonopoly regulation: ban a single firm who has a monopoly power

2. Labor market reforms

reducing the power of labor unions: structural unemployment
reducing unemployment benefits: structural, frictional, seasonal unemployment Increasing labor market flexibility
abolishing(폐지) minimum wages: structural unemployment
3. Incentive- related policies= tax cuts

AD Investment in human capital, labor market reforms→ decrease structural unemployment, raising the natural rate of
unemployment
Reduce cost-push inflations
In SR, interventionist policies- increase AD
Growth in potential output
Privatization: government revenue
Positive impact in equity: investment in human capital, infrastructure
DIs Time lags
New technology, Encourage competition→ increase structural unemployment, raising the natural rate of unemployment
Interventionist, incentive-related policies: increase public debt
Negative impact in equity: Market based, industrial policies
Harm environment