Definition of simple circular flow model A simple circular flow model of the macro economics containing two sectors

(business and household) and two markets (product and factor) that illustrates the continuous movement of the payments for goods and services between producers and consumers. The payment flow between the two sectors and two markets is conveniently divided into four segments representing consumption expenditures, gross domestic product, factor payments, and national income. The modern economy is a monetary economy. In the modern economy, money is used as a medium of exchange. While analyzing the circular flow of income in a two sector model of the economy, we assume: Assumptions of Circular Flow Model: (i) There are only two sectors in the economy, household sector and business sector. (ii) The business sector (or the firms) hires factors of production owned by the household sector and it is the sole producer of goods and services in the economy. (iii) The household sector (or the households) is the sole buyer of goods and services. It spends its entire income on the goods and services produced by the business sector. They are also suppliers of labor and several of other factors of production. (iv) The business sector sells the entire output to households. It does not store. There are, therefore, no inventories. (v) There are no savings and investment in the economy. (vi) The household sector receives income by selling or renting the factors of production owned by it. (vii) Government does, not exist for all such practical purposes (No public expenditures, no taxes, no subsidies, no social insurance contribution, etc.). (viii) The economy is closed one having no international trade relations. Simple circular flow model with two-sector, two-market According to circular flow of income in a two-sector economy, there are only two sectors of the economy, i.e., household sector and business sector. Government does not exist at all, therefore, there is no public expenditure, no taxes, no subsidies, no social security contribution, etc. The economy is a closed one, having no international trade relations. Y=C Where Y is C Income is Consumption

In a two-sector macro-economy, if there is saving by the household sector out of its income, the goods of the business sector will remain unsold by the amount of savings. Production will be reduced and so the income of the households will fall. In case the savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled by investment. Through investment, the equilibrium level between income and output is maintained at the original level. It is illustrated in the following figure:

The equilibrium condition for two-sector economy with saving is as follows:

Y=C+S

or

Y=C+I or S=I

or

C+S=C+I

Where Y C S I

is is is is

Income Consumption Saving Investment

When saving and investment are added to the circular flow, there are two paths by which funds can travel on their way from households to product markets. One path is direct, via consumption expenditures. The other is indirect, via saving, financial markets, and investment. Savings: On the average, households spend less each year than they receive in income. The portion of household income that is not used to buy goods and services or to pay taxes is termed Saving. Since there is no government in a two-sector economy, therefore, there are no taxes in this economy. The most familiar form of saving is the use of part of a households income to make deposits in bank accounts or to buy stocks, bonds, or other financial instruments, rather than to buy goods and services. However, economists take a broader view of saving. They also consider households to be saving when they repay debts. Debt repayments are a form of saving because they, too, are income that is not devoted to consumption or taxes. Investment: Whereas households, on the average, spend less each year than they receive in income, business firms, on the average, spend more each year than they receive from the sale of their products. They do so because, in addition to paying for the productive resources they need to carry out production at its current level, they desire to undertake investment. Investment includes all spending that is directed toward increasing the economys stock of capital. Financial Market: As we have seen, households tend to spend less each year than they receive in income, whereas firms tend to spend more than they receive from the sale of their products. The economy contains a special set of institutions whose function

is to channel the flow of funds from households, as savers, to firms, as borrowers. These are known as financial markets. Financial markets are pictured in the center of the circular-flow diagram in the above figure. Banks are among the most familiar and important institutions found in financial markets. Banks, together with insurance companies, pension funds, mutual funds, and certain other institutions, are termed financial intermediaries, because their role is to gather funds from savers and channel them to borrowers in the form of loans. Circular Flow of Income in a Three-Sector Model: Under three-sector model, the additional sector is the government. Two-sector economy is a hypothetical economy, whereas the three-sector economy is much more realistic. The inclusion of the government sector is very essential in measuring national income. The government levies taxes on households and on business sector, purchases goods and services from business sector, and attain factors of production from household sector. The following figure illustrates three-sector economy:

In the above diagram, in one direction, the household sector is supplying factors of production to the factor market. Business sector demands the factors of production from factor market. Inputs are used by the business sector, which produces goods and services that are purchased back by the households and the government. Personal income after tax or disposable income that is received by households from business sector and government sector is used to purchase goods and services and makes up consumption expenditure (or C). The money spent in the product market is the market value of final goods and services (or GDP). That money goes to business sector that pays it back in the form of wages, rent, profits and interests. Total spending on goods and services is known as aggregate demand. The total market value of output produced and sold is also known as aggregate supply. To measure aggregate demand in a closed economy, we simply add consumption spending (C), investment spending (I) and government spending (G). Therefore: Y=C+I+G WhereY is Income, C is Consumption, I is Investment, and G is Government Spending. Note that government spending (G) includes its buying of labour from factor market, buying of goods and services from product market, and transfer payments to the household sector. Transfer payments are payments the government makes in return for no service, for example, welfare payments, unemployment compensation, pension, etc. The government collects its money in the form of tax, which makes up most of the government revenue. But the government does not always balance their budgets. The government always tends to spend more than it takes in as taxes. The federal government almost always runs a deficit. The government deficit must be financed by borrowing in financial markets. Usually this borrowing takes the form of sales of government bonds and other securities to the public or to financial intermediaries. Over time, repeated government borrowing adds to the domestic debt. The debt is a stock that reflects the accumulation of annual deficits, which are flows. When the public sector as a whole runs a budget surplus, the direction of the arrow is reversed. Governments pay off old borrowing at a faster rate than the rate at which new borrowing occurs, thereby creating a net flow of funds into financial markets. Circular Flow of Income in a Four-Sector Model Two-sector economy and three-sector economy are briefly discussed in previous sections. These are hypothetical economies. In real life, only four-sector economy exists. The four-sector economy is composed of following sectors, i.e.:

(i) Household sector, (ii) Business sector, (iii) The government, and (iv) Transaction with rest of the world or foreign sector or external sector. The household sector, business sector and the government sector have already been defined in the previous sections. The foreign sector includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports (exports minus imports). The inclusion of fourth sector, i.e., foreign sector or transaction with rest of the world makes the national income accounting more purposeful and realistic. With the inclusion of this sector, the economy becomes an open economy. The transaction with rest of the world involves import and export of goods and services, and new foreign investment. It is illustrated in the following figure.

In four-sector economy, goods and services available for the economys purchase include those that are produced domestically (Y) and those that are imported (M). Thus, goods and services available for domestic purchase is Y+M. Expenditure for the entire economy include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus: Y+M=C+I+G+X Y = C + I + G + (X M) Where, C = Consumption expenditure

I G X M

= = = =

Investment spending Government spending Total Exports Total Imports Net Exports

X M=

Economy Leakages and Injections: Leakages: When households engage in savings and purchase of goods and services from abroad, we experience temporary withdrawal of funds from circulation. Therefore, leakages in the circular flow are savings, taxes and imports Injection: On the other hand, when we sell abroad (export) we receive income. More so when foreigners invest in our country the level of income will also increase. These two activities are injection into the income stream. Therefore, injections are investment, government spending and exports. Total Leakages = Total Injections

C + I + G + (X-M) = C + S + Net Taxes S + Net Taxes + Imports = I + G + Exports S = I + (G NT) + (X M) One way of thinking about the circular flow of income is to imagine a water tank. Investment, government spending and spending by foreigners is injected into the tank, and savings, taxes and spending on imports leak out. The injections and the withdrawals are equal to each other so the level in the tank is stable, or as economists like to say in equilibrium.

If injections are greater than withdrawals or leakages then the level in the tank will rise. If withdrawals are greater than injections then the level in the tank falls. If planned (I+G) is equal to planned (S+T), so that injections is equal to leakages and total spending is equal to total income and total demand is equal to total supply. Then we have a stable economy. If leakages are higher than injections i.e., planned savings plus taxes are greater than planned investment plus government spending (S+T > I+G), economy contracts resulting in inventory accumulation, too little spending and drop in prices. If injections are higher than leakages, i.e., planned investment plus government spending are greater than planned saving plus taxes (I+G > S+T), economy expands resulting in more goods and services produced, and higher prices. Unit-14 Income determination with Government and foreign trade Income determination model with Government: Two Three-Sector Model Two sectors are related to a closed economy in which there is no foreign trade and the four sector model is related with an open economy. Two Sector Model A two sector model of revenue ascertainment of a fiscal system comprises only of domestic and business sectors. Postulations The earnings ascertainment in a closed economy depends on the following postulations: 1. It is a two sector economy where only consumption and investment spending take place. Therefore, the total productivity of the financial system is the total of consumption and investment spending.

2. Investment is associated to net investment after subtracting depreciation. 3. It is a closed financial system where there are no overseas transactions. 4. There are no corporate industries in the financial system so that there are no corporate undistributed proceeds. 5. There are no commercial taxes, no earning taxes and no social security taxes so that disposable personal earnings parities NNP. 6. There are no transfer payments in the two sector model. 7. There is no statute. 8. The investment is self-governed. 9. The financial system is at less than full employment level of productivity. 10. The level of price remains invariable upto the limit of whole employment. 11. The money wage rate is invariable. 12. There is a constant function of consumption. 13. The interest rate is fixed. 14. The study is associated to short term. Elucidation Given these postulations, the equilibrium level of national income can be ascertained by the equality of aggregate demand and aggregate supply or by the equality of saving and investment. Aggregate demand is the summation of consumption expenditure on newly produced consumer goods by households and on their services C and investment expenditure on newly produced capital goods and inventories by businessmen (I). It is represented as the following: Y Disposable Personal Income Yd But Therefore, Y = = = C+I C+S Yd C+S

C+I =

Or

Where Y = national income, Yd = disposable income, C = Consumption, S = saving and I = Investment. In the above identities, C + I relate to consumption and investment expenditures which depict aggregate demand of an economy. C is the consumption function points the association between income and consumption outlay. I is the investment demand which is self governing. When investment demand (I) is added to consumption function (C), the aggregate demand function becomes C + I. C + S point is related to the aggregate supply of a financial system. That is the reason why the consumer goods and services are produced from total consumption outlay and aggregate savings are invested in the production of capital goods. In a financial system, the symmetry level of national income is ascertained by the parity of aggregate demand and aggregate supply (C + I = C + S) or by the equality of saving and investment (S = I). Income determination with foreign trade: The Four-Sector Model Four Sector Model of Income Determination To understand income determination in an open economy; let us turn to the four sector model which includes the effect of foreign trade along with the firms, households and government. In the case of foreign trade, exports(X) are injections and imports (M) are the outflows from the economy which causes the level of income to increase and decrease respectively. In the national income analysis, only the net of exports over the imports (X M ) is considered. Therefore, when X > M, there is an increase in national income and if X The export of a country is dependent on a multitude of factors which include: Out of these factors, only the first two are in the control of the domestic economy. Hence, the other variables cannot be included in the government policy variables. For the sake of simplicity, thus, we assume that the exports are determined by factors operating outside the economy under consideration. Hence, in the income determination model, X is considered to be given i.e., autonomous Xa. Similar to the exports, the imports are also determined by a number of factors such as: Here again, many of the factors are out of the control of the economy and hence, for simplification, we assume that the imports depend on the level of domestic income and the marginal propensity to import (mpm). Thus we can specify the import function as M = Ma + g Y

Where Ma = autonomous imports, g = eM/eY = mpm, assumed to be constant. Having specified the X and M functions, we can now arrive at the equilibrium equation of national income in the four sector model as, Y = C+ I + G + (X M) Where C = a + bYd I = IaG= Ga X = Xa M = Ma + gY Yd = Y Ta By substitution, we can rewrite the equation 2.26 as Y = a + b Y b Ta + Ia + Ga + Xa Ma gY Y - b Y + gY = = a + b Ta + Ia + Ga + Xa Ma Y = [1/(1-b+g)] [a + b Ta + Ia + Ga + Xa Ma] 2.27 2.26

The term 1/(1-b+g) in the above equation 2.27 is the foreign trade multiplier, when the consumption and imports are both a linear function of domestic income. We can arrive at this foreign trade multiplier (Fm) by considering increase in exports X by X, keeping other variables constant. Y + Y = [1/(1-b+g)] [a + b Ta + Ia + Ga + Xa + X Ma] 2.28 By subtracting equation 2.27 from equation 2.28, and dividng it by X on both sides, we get Y = [1/(1-b+g)] X Fm = Y/X = 1/(1-b+g)] Where b is the marginal propensity to consume (mpc) And g is the marginal propensity to import (mpm) When b= g in equation 2.29, the foreign trade multiplier becomes equal to unity. 2.29

If for simplicity purposes, we assume that tax is a constant factor, i.e T = T and transfer payment GT = 0, then, Y = C + I + G + ( X M) Where C = a + b( Y-T) And M = M + mY, where M is constant, autonomous import and m is marginal propensity to import. Therefore, Y = a + b( Y-T)+ I + G + ( X M - mY ) 1 (a bT + I + G + X M ) Y= 1 b + m 1 = Foreign trade multiplier 1 b + m A Complete 4 sector model If we drop the above assumptions, and assume that _ T = T + tY And GT = GT >0 Then, Y = C + I + G+ ( X M) _ Y = a + b ( Y - T - tY + GT ) + I + G + ( X - M - mY) Simplifying we get, _ 1 (a bT + bGT + I + G + X M ) Y= 1 b(1 t ) + m 1 =Foreign trade Multiplier 1 b(1 t ) + m Taxation and imports have a negative effect on the multiplier. Exercise C = 100 + b(Y T tY + GT ) I =200 G=100 T =100 X = 20 B= 0.8
_ _

GT =50 M = 10+ 0.1Y t = 0.25