Economic Issues: An introduction

Outcome Two: The Circular Flow of National Income

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Lesson Structure

1. Introduction

2. The ‘two sector’ model

3. A more realistic model: Injections Withdrawals

4. Changes in injections and withdrawals

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5. Circular flow and Keynesian Demand Economic Policies: Problems

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2. The Two Sector Model

How an economy operates via a simplistic model

The process of production and consumption Two basic sectors:

Firms: wealth producing sector Households: consuming sector

Represents how wealth is created in an economy

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FirmsHouseholds

Incomes (Wages, interest, rent, profits)

Factors of production (land, labour, capital

and enterprise)

Consumer spending

Output of goods and services

Flow of resource inputs and outputs

Flow of income and expenditure

The ‘Two Sector’ Model

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There are two kinds’ relationships between firms and households:

a. Monetary relationship

b. Physical relationship

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A circular flow of income is created

National Income = National Expenditure = National Output

(Assuming that an economy consists of only two sectors: ‘firms’ and ‘households’).

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3. Injections and Withdrawals

The two sector model in its present form would be realistic if:

Firms paid out all the income they receive to domestic households

Households used all of their income to consume the output produced by domestic firms

Money would continue to flow directly between firms and households

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In reality…

Some income will leave the circular flow

Some income will enter the circular flow

Account for the government and foreign sector

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Enter Injections and Withdrawals

The level of national income is influenced by:

Withdrawals (‘leakages’) from the circular flow of income (income entering the flow)

Injections into the circular flow of income (income leaving the flow)

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Injections (J) into the Circular Flow

Injections into the flow will result in an increase in the level of national income

Three types of injections:

a. Government spending (G)b. Investment (I)c. Exports (X)

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Firms Households

Income

Consumption

Investment (I)

Government Spending (G)

Exports (X)

Injections (J) into the Circular Flow

Injections = an increase in national income

Total Injections = G + I + X

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Withdrawals (W) from the Circular Flow

Withdrawals from the flow will result in a decrease in the level of national income

There are three types of withdrawals:

a. Savings (S)b. Taxation (T)c. Imports (M)

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Firms

Income

Consumption

Savings (S)

Taxation (T)

Imports (M)

Withdrawals (W) from the Circular Flow

Withdrawals represent a leakage = a decrease in national income

Withdrawals: S+T+M

Households

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The Circular Flow of Income

Firms

Income

Consumption

Investment (I)Savings (S)

Government Spending (G)

Exports (X)

Taxation (T)

Imports (M)

Households

Injections (J) Withdrawals (W)

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4. Changes in Injections and Withdrawals

How do changes in injections and withdrawals affect the level of national income in an economy?

Lets examine what happens when…

a. Injections are greater than withdrawals

b. Injections are less than withdrawalsc. Injections and withdrawals are equal

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Changes in Injections and Withdrawals

a. If injections are more than withdrawals: National income will rise More income entering than leaving the economy

b. If injections are less than withdrawals: National income will fall More income leaving than entering the economy

And Finally…

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Equilibrium in the Circular Flow

c. If injections are equal to withdrawals: National income remains stable The economy will be in a state of

equilibrium

Amount of income entering equals the amount of income leaving the economy

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Class Exercise: What Happens to National Income If…

1. Individuals decide to save more of their money?

National income will fall as savings represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services

2. The Government increases spending in the economy e.g. builds 10 new hospitals?

National income will rise as Government expenditure represents an injection of income into the circular flow. This would increase the level

of employment in the economy, in turn increasing the amount of

consumer spending and income generated.

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Class Exercise: What Happens to National Income If…

3. Demand for UK exports increases?

National income will rise as export spending represents

an injection of income into the circular flow.

4. Level of investment in the UK increases?

National income will rise as increased investment represents an injection of income into the circular flow

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5. The Government increases the amount of tax paid on goods and services (VAT)?

National income will fall as taxation represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services

6. The demand for imports in the UK increases?

National income will fall as import spending represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services. This income will enter the circular flow of income in another Country.

Circular Flow/Keynesian Economic Policy: Problems

The level of national income in the economy will influence the level of unemployment-why?

We have to consider aggregate demand (total demand for all goods and services produced in the economy)

If AD in the economy falls, national income decreases

If less goods and services are produced, this will lead to higher unemployment

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Unemployment caused by a decrease in aggregate demand = demand deficient unemployment

This type of unemployment is associated with John Maynard Keynes

Circular Flow/Keynesian Economic Policy: Problems

If unemployment is caused by a lack of AD, the government should intervene in the economy to increase AD by using fiscal policy.

Fiscal policy can be used to increase AD and employment by increasing government spending and/or decrease taxation

Example

Increasing government expenditure to create more employment and to stimulate an increase in demand for goods and services (multiplier effect).

However, increasing AD to lower unemployment has various problems:

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Problem One: Inflation

If unemployment is caused by a lack of AD, the government should intervene in the economy to manage AD e.g. increasing government expenditure to create more employment and stimulate an increase in demand for goods and services (multiplier effect)

However, as the economy nears full employment it becomes more difficult for producers to increase their output.

If demand continues to rise and producers become unable to respond to these shortages, then prices will be forced upwards

Inflation is one of the criticisms associated with increasing government spending to increase national output and employment

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Problem Two: Budget Deficit/Crowding Out

If the government increases expenditure to lower unemployment, this could lead to a budget deficit

Budget deficit: government expenditure greater than revenue from taxation

This increases the level of government debt in the economy

The government will have to borrow money to eliminate this deficit

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Problem Two: Budget Deficit/Crowding Out

Increases in public borrowing can result in interest rates increasing, making the cost of borrowing more expensive for the private sector businesses. This situation can be referred to as ‘crowding-out’ the private sector.

An increase in government debt and crowding out of the private sector are two additional consequences associated with increasing government spending to increase national output and employment

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Problem Three: Time Lags

The use of government expenditure to lower unemployment and raise national output can be subject to time lags. E.g. increase government expenditure to lower unemployment: the policy may only come into effect when the economy has already recovered and experiencing a boom

Time lags is another consequence associated with increasing government spending to increase employment and national output

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Problem Four: Dependence on Government Intervention

Increasing government expenditure to increase levels of national output and employment was one of the main policies applied by successive governments in the 1950s and 1960s

Unemployment reached historically low levels but increased government intervention through increased government expenditure was criticised by the 1970s as this policy proved to be unworkable in solving the economic difficulties experienced, particularly the economic problem of stagflation (high unemployment and high inflation)

This is an additional consequence associated with increasing government spending to increase national output and employment

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Summary

Circular Flow is a model of the economy

Relationship between firms and households

Output=Income=Expenditure

For our model to be realistic, we have to consider: Injections into the flow Withdrawals from the flow

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Three types of Injections: Government spending Exports Investment

Three types of Withdrawals: Taxation Imports Savings

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a. If injections are more than withdrawals: National income will rise

b. If injections are less than withdrawals: National income will fall

c. If injections are equal to withdrawals: National income remains stable The economy will be in a state of equilibrium