PAN African e-Network Project

Diploma in Business Management

Managerial Economics & Analysis
Semester - I
Session - 9

Ms. Tavishi

The Circular Flow Model

Circular Flow of Income

The cyclical operation of demand, output,
income, and new demand
Leakages: flows out of circular flow when
resource income is received and not spend
directly on purchases from domestic firms
Injections: Added spending in circular flow
that does not come out of current resource
income

Circular Flow - Simple Model

Resource Income
$$$

Productive Services

Businesses

Households

Goods and Services

$$$

Spending for Goods and Services

Stable Economy
If all income is spent
business will sell all goods, and
will be induced to produce all goods again

Flow with Leakages/Injections

Resource Income

Businesses

Investment

Spending

Loanable
Funds

Government

Saving

Taxes

Spending for Goods and Services

Households

Leakages and Injections

Leakages in the circular flow
savings
taxes

Injections in the circular flow

investment
government spending

Savings and Investment

If planned (I+G) = planned (S+T)
so that injections = leakages
and total spending = total income
and demand = supply
thenwe

have a stable economy

Contracting Economy
If leakages are Higher than injections
(Planned S+T > Planned I+G), economy
contracts resulting in
inventory accumulation
too little spending
drop in prices

Expanding Economy
If injections are Higher than leakages
(Planned I+G > Planned S+T), economy
expands resulting in
more goods and services produced
higher prices

Government and the

Circular Flow

Balanced budget:

amount spent by government = amount

collected in taxes

Surplus budget
amount spent by government = less than that
collected in taxes

Deficit budget
amount spent by government = more than
that collected in taxes

International Trade and the Circular

Flow
IMPORTS are a leakage
EXPORTS are an injection
If exports = imports, the circular flow
is in balance
Usually it is not balanced
called a trade deficit, because imports
(leakages) are greater than exports
(injections)

The Circular Flow Diagram

Motivation
The Great Depression caused a rethinking
of the Classical Theory of the macro
economy. It could not explain:
Drop in output by 30% from 1929 to 1933
Rise in unemployment to 25%

In 1936, J.M. Keynes developed a theory

to explain this phenomenon.

Aggregate Demand and Supply

Aggregate Demand (AD)

Aggregate Demand
The sum of all expenditure in the economy over a
period of time

Macro concept WHOLE economy

Formula:
AD = C+I+G+(X-M)
C= Consumption Spending
I = Investment Spending
G = Government Spending
(X-M) = difference between spending on imports
and receipts from exports (Balance of Payments)

Aggregate Demand Curve

Inflation

Thea lower
This
At
higher
level of
level
rate
output
of
of
At an
level
will
inflation
National
be inflation
associated
(3.0%)
Income
of 2%,
the
ADrates
with
rising
requires
ainterest
particular
fewer
units
curve
gives
level
mean
of
labour
ofthat
C,aIlevel
and
of output
of Y1 rises
(X-M)
unemployment
all have
which
negative
to
7% we
shown
effects
will call
by on
UU=
= 5%
AD
7%
NY falls to Y2

3.0%

2.0%
AD
Y2
U = 7%

Y1
U = 5%

Real National Income

Consumption Expenditure
Exogenous factors affecting consumption:

Tax rates
Incomes short term and expected income over lifetime
Wage increases
Credit
Interest rates
Wealth
Property
Shares
Savings
Bonds

Investment Expenditure
Spending on:

Machinery
Equipment
Buildings
Infrastructure

Influenced by:

Expected rates of return

Interest rates
Expectations of future sales
Expectations of future inflation rates

Government Spending

Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order

Import Spending (negative)

Goods and services bought from abroad represents
an outflow of funds from the country (reduces AD)

Export Earnings (Positive)

Goods and services sold abroad represents a flow
of funds into the UK (raises AD)

Aggregate Supply
Inflation

AS

Economy starts to overheat

Y1

Yf

Between Y1 and Yf,

The
shape
the
AS
Yf
Anrepresents
output
level
Full
of
Y1
increases
in of
capacity
are
This
shape
curve
important
Employment
wouldissuggest
thein
possible
but
theOutput
nearer
reflects
the
economy
to Yf,
determining
the
at
economy
this
point
isagets
working
the
morefull
problems
are to
outcome
in
the
economy
below
iscapacity
working
Keynesian
view
experienced
with
economy
full
andcapacity
there would
and be
of
the
AS
curve.
acquiring
resources
to
cannot
widespread
produce
any
boost production
more.
unemployment.
(production
bottlenecks)
especially labour skills
shortages.

Real National Income

Aggregate Supply
Inflation

AS1

AS2
Increases in
capacity can
occur as a result
of a shift in AS
(akin to a shift
outwards of the
Production
Possibility
Frontier) (PPF)

Yf1

Yf2

Real National Income

Aggregate Supply
Inflation

SRAS 1
SRAS
SRAS 2

SRAS
assumes
Short run
costs
suchsupply
as
aggregate
(SRAS)
overall assumes
wage
firms
only able to
rate remain
increase
output at
fixed, changes
in
higher costs (e.g.
such costs cause
overtime
a
shift in the
payments)
SRAS
therebycurve
pushing
(exogenous
up price level
shocks input
costs)

Real National Income

Aggregate Supply
Inflation

LRAS

Yf

This is because they

Classical
believe that in the
economists
long run, there will be
no
unemployment
of
assume
the long
resources because
run aggregate
markets will clear,
supply
curve
thus whatever
the
rate of inflation,
firms
(LRAS)
is vertical
will
supply the
(perfectly
maximum capacity of
inelastic).
the economy.

Real National Income

Aggregate Supply
Inflation

AS
For our analysis,
we will assume
the AS curve
looks like this!

Real National Income

Putting AD and AS together

AS

Inflation

2.5%
2.0%

A shift in the AD
In
thisto
situation,
curve
AD1 as athe
economy
bein
result of awould
change
operating
at the
less
any or all of
than
capacity,
there
factors
affecting
AD
would
be
would increase
unemployment
growth, reduce and
the
economy might
unemployment
but at
be
growing
only
a cost of higher
slowly.
inflation (a trade-off)

AD 1
AD
Y1

Y2

Yf

Real National Income

Putting AD and AS together

AS

Inflation

3.5%

Further increases in
AD would lead to
successively
smaller increases in
growth and
employment at the
cost of ever higher
inflation.

AD2
2.5%
2.0%

AD1
AD
Y1

Y2

Yf

Y3

Real National Income

Sustained Growth
Inflation

AS

AS1
Sustained
growth (not to
be confused with
sustainable
economic
growth) occurs
when AS and AD
rise at similar
rates national
income can rise
without effects
on inflation

2.0%

AD2
AD
Y1

Y2

Real National Income

Sustained Growth
Inflation

AS

AS1
Sustained
growth (not to
be confused with
sustainable
economic
growth) occurs
when AS and AD
rise at similar
rates national
income can rise
without effects
on inflation

2.0%

AD2
AD
Y1

Y2

Real National Income

Simple Keynesian Model

National Income Determination
Two-Sector National Income Model

Exogenous & Endogenous Variables

Exogenous Variable
the value is determined by forces outside the
model
any change is regarded as autonomous
I, G, X ( Micro: Income/Population)

Endogenous Variable
the value is determined inside the model
factor to be explained in the model
Y, C, M ( Micro: Price/Quantity)

Linear Functions
A function specifies the relationship
between variables
y is the dependent variable
x is the independent variable
y=f(x)

Linear Functions

y=f(x)
y= c
y=mx
y=c+mx
m, c are exogenous variables
y, x are endogenous variables

Linear Functions

Consumption Functions
C= f(Y)
C= C
C= cY
C= C + cY

Linear Functions

C, c are exogenous variables

C, Y are endogenous variables
Y is independent variables
C is dependent variables

Linear Functions
The parameter C is autonomous consumption
It summarizes the effects of all factors on
consumption other than national income.
What is the difference between a change in
exogenous variable (autonomous change) and a
change in endogenous variable (induced
change)?

Linear Functions
C= f(Y, W)
If wealth is deemed as a relevant factor
but is not explicitly included in the
consumption function C=C+ cY
a rise in wealth W will lead to a rise in
the exogenous variable C
graphically, the consumption function C
will shift upwards

Aggregate Demand & Supply

Aggregate Demand
the relationship between the total amount of
planned expenditure and general price level
(v.s. aggregate expenditure E)

Aggregate Supply
the relationship between the total amount of
planned output and the general price level

Aggregate Demand & Supply

Price Level
Aggregate Supply

Equilibrium: no tendency to change and

the values of the endogenous variables
will remain unchanged in the absence of
external disturbances
Aggregate Demand
National Output

Aggregate Demand & Supply

P

AS

When AS is vertical
A shift of AD will cause a change
In P only but have no effect on Y

AD2
AD1

Aggregate Demand & Supply

P

AD1

AD2

When AS is horizontal
A shift of AD will cause a change in Y only but
have no effect on P

AS

Aggregate Demand & Supply

AS

AD

Ye

Yf

Aggregate Demand & Supply

The Upward Sloping AS
When the economy is close to but below full
employment level Y < Yf, the attempt to raise
output by increasing aggregate demand will
face supply side limitations
both price and output will increase

Aggregate Demand & Supply

The Vertical AS
When full employment is attained Y = Yf, an
increase in aggregate demand can only cause
prices to rise

Aggregate Demand & Supply

The Horizontal AS
When output is far below Yf, the equilibrium
output is determined by AD
The supply side has no effect on income level
as firms could supply any amount of output at
the prevailing price level
The Keynesian Model analyses the situation
of an economy with fixed prices and high
unemployment Y < Yf

National Income Determination

Model

Assumptions:

National income Y is defined as the total real

output Q
A constant level of full national income Yf
Serious unemployment, i.e., there are many
idle or unemployed factors of production

National Income Determination

Model (contd)
Income / output can be raised by using
currently idle factors without biding up prices
Price rigidity or constant price level
There are only households and firms (2sector). No government and foreign trade

National Income Identities

An identity is true for all values of the
variables
In a 2-sector economy, expenditure
consists of spending either on consumption
goods C OR investment goods I.
Aggregate expenditure (AE OR E) is ,by
definition, equal to C plus I
EC+I

National Income Identities

National income Y received by
households, by definition, is either saved
S OR consumed C.
YC+S

National Income Identities

Aggregate expenditure E is, by definition,
equal to national income Y
YE
C+SC+I
SI

Equilibrium Income
Equilibrium is a state in which there is no
internal tendency to change.
It happens when
firms and households are just willing to
purchase everything produced Y = E (v.s.
Micro: Qs = Qd)
Income-Expenditure Approach
planned saving is equal to planned
investment S = I
Injection-Withdrawal Approach

Equilibrium Income
What is the definition of GNP (/ GDP) in
national income accounting?
The total market value of all final goods
and services currently produced by the
citizens (/within the domestic boundary) of
a country in a specified period

Equilibrium Income
Ex-ante Y > E Excess supply
planned output > planned expenditure
unexpected accumulation of stocks OR
unintended inventory investment OR
involuntary increase in inventories

In national income accounting, this amount Y-E is

treated as (unplanned) investment by firms

Equilibrium Income
Ex-post Y= E
Actual (Realised)= Planned + Unplanned
Expenditure
Expenditure Investment
Actual (Realised) Output = Actual Expenditure

Firms will reduce output

Equilibrium Income
Ex-ante Y < E Excess Demand
planned output < planned expenditure
unexpected fall in stocks OR
unintended inventory dis-investment OR
involuntary decrease in inventories

However, in national income accounting, this

amount E - Y consumed is not currently
produced

Equilibrium Income
Ex-post Y= E
Actual (Realised)= Planned - Unplanned
Expenditure
Expenditure Dis-investment
Actual (Realised) Output = Actual Expenditure

Firms will increase output

Equilibrium Income
Ex-ante Y= E Equilibrium
There is no unintended inventory
investment OR dis-investment
Ex-post Y=E

Equilibrium Income
When there is excess supply, i.e., planned
output > planned expenditure, firms will reduce
output to restore equilibrium
When there is excess demand, i.e., planned
expenditure > planned output, firms will increase
output to restore equilibrium
In the Keynesian model, it is aggregate demand
that determines equilibrium output. Remember
the horizontal AS [slide 19]

Consumption Function
Now, we will look at the 1st component
of the aggregate expenditure E C + I
i.e. C
Empirical evidence shows that
consumption C is positively related to
disposable income Yd
Yd = Y since it is a 2-sector model

Consumption Function
Autonomous Consumption C
It exists even if there is no income. This
can be done by dis-saving, i.e., using the
past saving
Then, saving will be negative when income
is zero.
It is totally determined by forces outside
the model
What happens to the consumption
functions if C ? Or C ?

Consumption Function
C = y-intercept
In C

C = C

C = cY

C = C + cY

Consumption Function
Marginal Propensity to Consume MPC = c
It is defined as the change in consumption per unit
change in income
MPC = C / Y
It is the slope of the tangent of the consumption
function
For a linear function, MPC is a constant
What does the consumption function C look like if
MPC is increasing? Decreasing?
It is assumed that 0 < MPC < 1
What happens to the consumption functions if c ?
or c ?

Consumption Function
MPC = slope of tangent
in MPC or in c

C = C

C = cY

C = C + cY

Consumption Function
Average Propensity to Consume APC
It is defined as the ratio of total consumption
C to total income Y
APC = C / Y
It is the slope of ray of the consumption
function
When C = C OR C = C + cY, APC decreases
when Y increases.
When C = cY, APC = MPC = c = constant

Consumption Function
APC = slope of ray

C = C

C = cY

C = C + cY

Consumption Function

Relationship between APC and MPC

C = C
Divide by Y
C/Y = C/Y
APC = C/Y
APC when Y
Slope of ray flatter when Y
Slope of tangent = MPC = c = 0

Consumption Function

Relationship between APC and MPC

C = cY
Divide by Y
C/Y = c
APC = MPC = c
Slope of ray=Slope of tangent=constant=c

Consumption Function

Relationship between APC and MPC

C = C + cY
Divide by Y
C/Y = C/Y + c
APC = C/Y + MPC
C +ve
APC > MPC
Slope of ray steeper than slope of tangent
Slope of tangent constant
Slope of ray flatter when Y
APC when Y

Investment Function
Lets look at the 2nd component of the
aggregate expenditure E C + I
An investment function shows the
relationship between planned investment I
and national income Y
It can be a linear function or a non-linear
function

Investment Function
Again, there can be 3 investment functions
I = I
I = iY
I = I + iY
Economists usually use the first one, i.e., I= I as
investment is thought to be correlated with
interest rate r, instead of Y
I , i are exogenous variables
I , Y are endogenous variables

Investment Function
Autonomous Investment I
It is independent of the income level and is
determined by forces outside the model,
like interest rate.
I is the y-intercept of the investment
function

Investment Function
Marginal Propensity to Invest i
It is defined as the change in investment I per
unit change in income Y
MPI = I / Y
MPI would not correlate with Yd
It is the slope of tangent of I
It is also determined by forces outside the model

Investment Function
MPI = i =slope of tangent
I = y-intercept
API when Y
MPI =0

I = I

I = iY

I = I + iY

Aggregate Expenditure Function

Given E = C + I
C = C + cY
I = I
E = I + C + cY
E = E + cY

Aggregate Expenditure Function

I

C, I, E

Slope of tangent = c
Slope of tangent=0

Y
I = I

C = C+cY

E = I + C+ cY

Aggregate Expenditure
Function

Autonomous Change
When C or I E shift upward
When c slope of E steeper rotate
Induced Change
When Y E move along the curve

Output-Expenditure Approach
National income is in equilibrium when
planned output = planned expenditure
We have planned expenditure E=C+I
Equilibrium income is Ye=planned E
A 45-line is the locus of all possible points
where Y = E
When E = planned E, Y = Ye

Output-Expenditure Approach
Y=E

C, I, E

Planned E=C +I

Planned E < Y
Unintended
inventory
investment

Y=planned E

Planned E>Y

Actual E = Y

Unintended
inventory disinvestment
Actual E =Y

Y
Y

Ye

Output-Expenditure Approach

Y = planned E
Y = I + C + cY
Y = E + cY
(1-c)Y = E
Equilibrium condition
Y=
E
1
1-c

Output-Expenditure Approach
If C or I E E Ye
If c E steeper Ye
If we differentiate the equilibrium
condition,
Y/E = 1/(1-c)
Given 0 < c < 1 1/(1-c) > 1
E Ye by a multiple 1/(1-c) of E

Expenditure Multiplier 1/(1-c)

Assume c=0.8, E = 100
The one who receive the $100 as income
will spend 0.8($100)
then the one who receives 0.8($100) as
income will spend 0.8*0.8($100)
The process continues and the total
increase in income is
$100+0.8($100) +0.8*0.8($100) +

Expenditure Multiplier 1/(1-c)

The total increase in income is actually the
sum of an infinite geometric progression
which can be calculated by the first term
divided by (1- common ratio)
The first term here is E = $100 and the
common ratio is c =0.8
The sum of GP is E * multiplier

Saving Function
We have Y C + S [slide 27]
Saving function can simply be derived from the
consumption function
S=YC
if C = C + cY
S = Y C cY
S = -C + (1-c) Y
S = S + sY S= -C s = 1 - c
S < 0 if C >0 S = 0 if C = 0

Saving Function
S

S = sY

S
S = S+ sY

S = (1-c)Y

S =-C+(1-c)Y

Slope of tangent = s =1- c

Y > Y*
Y

S+ve

Y*
S

Slope of ray = slope of tangent

Slope of ray < slope of tangent

Saving Function
Autonomous Saving S
Since S= -C + (1-c)Y
If C= 0 when C= cY
S = (1-c)Y S = 0
If C +ve when C = C + cY
S = -C + (1-c)Y S ve
If Y= 0 S = -C Dis-saving

Saving Function
Marginal Propensity to Save MPS = s
It is defined as the change in saving per unit
change in disposable income Yd OR income Y
(in a 2-sector model)
MPS = S/ Y
It is the slope of tangent of the saving function
MPS is a constant if the consumption / saving
function is linear

Saving Function
Average Propensity to Save APS
It is defined as the total saving divided by
total income
APS = S/Y
It is the slope of ray of the saving function

Saving Function
Average Propensity to Save APS (contd)
When S= sY
APS = MPS = s = constant

When S=S+ sY
APS < MPS as S ve
APS ve when Y < Y* [slide 62]
APS = 0 when Y = Y*
APS +ve when Y > Y*
APS when Y

Saving Function

Y=C+S
Differentiate wrt. Y
Y/Y=C/Y + S/Y
1= MPC + MPS
1=c+s
[slide 61]

S = S + sY Divided by Y
S/Y = S/Y + s
APS=S/Y+MPS [slide 66]

How to determine Ye?

Y=E
C, S, I, E
Planned Y = planned E

+ve S

Planned I

-ve S

Planned C

Y<C

Y*=C

Ye

Y>C

Y=E

Y<C
Y<E

Y = C S =0
No Dis-saving
Y<E
Unintended Inventory Dis-investment
I
Actual I =Planned IPlanned
Unintended
I

Planned C

Planned Y < Planned E

Ye

E=C+I

Y=E

Y > C S +ve
Saving
Y>E
Unintended Inventory Investment
I
Actual I =Planned Planned
I + Unintended
I

Planned C

Ye
How about Y*<Y<Ye?

Planned Y > Planned E

E=C+I

Injection-Withdrawal Approach
Remember the national income identity S
I
The equilibrium income happens when
planned Y= planned E as well as planned
S = planned I

Injection-Withdrawal Approach

S+ sY = I
sY = I S
S=-C s=1-c
(1-c)Y = I + C = E
Equilibrium condition
Y=
E
1

1-c

Equilibrium Income
No matter which approach you use, you
will get the same equilibrium condition.

Equilibrium Income
Write down the investment function I first. Then
write down the saving function S. Remember
planned S = planned I when Y is in equilibrium
{Injection-Withdrawal}
Write down the investment function I as well as
the consumption function C. Together they are
the aggregate expenditure function E.
Remember planned Y = planned E when Y is in
equilibrium {Output-Expenditure}

Y=C
Y<C

Y=E
Y>C

E=C+I

C=C+cY

E=C+I

S = S + sY
C
I

S=- C

I=I

Planned Y=Planned E

Unintended
Inventory
Investment

E=C+I

S=S+sY
Unintended Inventory
Disinvestment

E=C+I

Unintended Inventory
Disinvestment

Planned S=Planned I

Unintended
Inventory
Investment
I=I

Paradox of Thrift
This is an example of the fallacy of
composition
Thriftiness, while a virtue for the
individual, is disastrous for an economy
Given I = I
Given S = S + sY OR S = -C + (1-c)Y
Now, suppose S
Will Ye increase as well?

A rise in thriftiness causes a decrease in national

income but no increase in realised saving.

S=S +sY
S= S+ sY
Excess Supply
I=I

Ye

Paradox of Thrift
If a rise in saving leads to a reduction in interest
rate and hence an increase in investment (Think of
the loanable fund market), national income may not
decrease
Ye will increase if I increase more than S
Ye will remain the same if I increase as much as S
Ye will decrease if I increase less than S

I > S

S=S +sY
S= S+ sY
I=I
I=I

Ye

I = S

S=S +sY
S= S+ sY
I=I
I=I

Ye

=Ye

I < S

S=S +sY

The reduction in Ye is less than

the case when I does not
increase

S= S+ sY
I=I
I=I

Ye

Thank You
Please forward your query
To: tavishie@amity.edu