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Understanding the economy

as a series of continuousflows

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The Simple Two Sector Model

Assume the economy is made up of two sectorsfirms and households.

Firms produce products which they sell in theProduct Market.

Households buy products in the Product Market. Firms buy resources in the Resource Market.

Households sell resources in the Resource Market.

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The Simple Two Sector Model

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The Two Sector ModelWith a Financial Market

Now assume that households do not spend all oftheir income, i.e., they save.This represents a leakage from the circular flow.

Assume firms need capital to produce goods and

services, thus they must engage in investmentspending.This represents an injection into the circular flow.

Financial intermediaries perform the function ofbringing savers and investors together.

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The Two Sector ModelWith a Financial Market

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The Three Sector Model

Our two sector model is not realistic inanything but the most primitive society.

Lets assume we have a government

sector. What do governments do?

They tax. (A leakage)

They spend. (An injection)

How does the government affect ourcircular flow?

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The Three Sector Circular FlowModel

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The Four Sector Model

In the real world, no country exists in isolation. Nations of the world interact with one another by

buying from and selling to each other.

We buy imports from foreign countries. (A leakage)

We sell exports to foreign countries. (An injection)

Add imports and exports to our circular flow.

How does the rest of the world affect the circularflow model?

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The Four Sector Circular Flow Model

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GDP in an Open Economy with GovernmentGovernment Spending and Taxes: Government spending and taxation policies

affect equilibrium GDP in two important ways. First, government spending is

part of autonomous spending , that is, it is an exogenous element of spendingin the economy, as it directly adds demand for the economys current output

of goods and services. Second, in deriving disposable income, taxes must be

subtracted from NI, and government transfer payments (state pensions and

unemployment allowances) must be added. Tax revenues may be thought of

as negative transfer payments in their effect on desired aggregate spending.

Tax payments reduce disposable income relative to NI; transfers raise

disposable income relative to NI. Net taxes are total tax revenues received by

the government minus total transfer payments made by the government. A

governments plans for taxes and spending define its fiscal policy, which has

important effects on the level of GDP in both the short and the long run.

The Budget Balance: The budget balance is the difference between total

government revenue and total government spending-or equivalently, net taxes

minus government spending. When revenues exceed spending, the

government is running a budget surplus and reverse is budget deficit and

when there is neither deficit nor surplus then is called as balanced budget.

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Government Spending and Taxes: The balance of trade responds to changes in GDP, the

price level, and the exchange rate. Exports depend on spending decisions made by foreign

consumers or overseas firms that purchase domestic goods and services. Therefore,

exports are determined by influences outside of the home country. This is autonomous, or

exogenous, spending from the point of view of the determination of domestic GDP.Imports, however, depend on the spending decisions of domestic residents. Most

categories of spending have an import content-like outsourcing of products for making

any finished goods like TV, ACs, Cars etc. Thus, imports rise when the other categories of

spending rise. Because consumption rises when the income of domestic consumers rises,

imports of foreign produced consumption goods, and of materials that go into the

production of domestically produced consumption goods also rises with domestic income.

Foreign GDP: An increase in foreign GDP, other things being equal, will lead to an increase

in the quantity of domestic-produced goods demanded by foreign countries, that is, to an

increase in our exports and vice-versa.

Relative International Prices: Any change in the prices of home produced goods relative tothose of foreign goods will cause both imports and exports to change. What circumstances

will cause relative international prices to change? a) International differences in inflation

rates, b) and changes in exchange rates.

Exchange rate changes may be brought about by changes in interest rates implemented by

the monetary authorities. The domestic currency will generally appreciate when the

domestic interest rate is raised, and vice-versa.

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Changes in Aggregate Spending

1. Fiscal Policy: what should the government do for increasing aggregate spending in

an economy? Keynesian philosophy also to be dealt with.

Changes in government spending

Changes in tax rates

----Tax rates and the Multiplier ( the lower is the income tax rate, the larger is the

simple multiplier as MPC will rise.

Balanced budget changes ( changes made in spending and tax rate ) A balanced

budget increase in government spending will have a mild expansionary effect on

GDP, and a balanced budget decrease will have a mild contractionary effect.

2. Monetary Policy: It works via the effects of interest rates on aggregate spending.

Interest rate changes effects consumption. Higher interest rate encourage people to

cut their spending in order to save more and discourage borrowing in order to spend

more. Higher interest rate also discourage investment. Interest rate changes lead to a

shift in autonomous spending ( whether it be consumption, investment, or net

exports)