Download Circular Flow 2

Economic Activity
Introduction
The purpose of an economy is to produce goods
and services for the benefit of its consumers.
• HOW does it do this?
• how WELL does it do this?
Fundamental Questions
• How is an economy performing?
• How do we measure this performance?
• What are we comparing this performance to?
• What has (or has not) contributed to this level of
performance?
Overview
We will be building an economic model that will
allow us to look at
• the various parts/sectors of an economy,
• how they fit together,
• how they relate to one another, and
• how they contribute to the functioning of the
economy.
The Two Sector Economy
This is the simplest form of economy, typical of
small and undeveloped societies.
The Private Sector is made up of:
• Consumers (Households) who must earn some form of
income to be able to satisfy their needs and wants.
• Producers (Firms) who must employ resources to be able to
create the goods and services they wish to provide.
The second sector is the Financial Sector:
• coordinating the distribution of household savings to those
producers who need funds.
The Model
Households earn income by “selling” their
productive resources to Firms
Productive Resources
Income
HOUSEHOLDS
FIRMS
The Model
Firms use these resources to create the goods and
services demanded by Households.
Productive Resources
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Goods and Services
The Model
Money flows around the inner circle,
whilst resources and commodities flow around the
outside.
Productive Resources
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Goods and Services
These outside flows are called Real Flows
The Model
These money flows are a measure of the value of
the commodities being exchanged.
Productive Resources
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Goods and Services
For example, the amount spent by Households will equal
the value of the goods and services produced by firms. So,
(in this particular economy) consumer spending will indicate
how much Firms have produced.
The Model
Income not spent by Households is saved with the
From now on only the MONEYFLOWS will be
Financial Sector, who then lends these funds to
shown on the model.
Firms who wish to invest in further development.
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Savings
Investment
FINANCIAL SECTOR
Again, the money flows are all anti-clockwise.
The Model
The two flows across the bottom will always equal
the Income flow across the top.
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Savings
Investment
FINANCIAL SECTOR
Measuring Performance
• How much is an economy producing?
• What has contributed to this?
Measuring
Performance
We can measure the performance of an economy
by measuring the flow of money around the
system, either the flow of income
or the flows of consumer spending and
saving.
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Savings
Investment
FINANCIAL SECTOR
Either way, the two measures will come out equal. This is the value of all
goods and services produced by the economy, called Gross Domestic Product
So, as an equation: GDP = Y (income)
and GDP = C (consumption spending) + S (savings)
and GDP = C + I (investment)
All of these measures will give the same answer.
Measuring
Performance
As the central goal of any economy is the
production of goods and services, so any measure
of its performance must indicate the value of
goods and services produced.
C
represents consumer spending and therefore the value of consumer goods
created in the economy.
I
represents spending on capital or producer goods and therefore the value
of those goods created in the economy.
In a Closed Economy, therefore, C + I will represent the total production of
goods and services.
By examining these figures and comparing them to those of previous years you
can study the contribution made by different sectors to the economy.
Measuring
Performance
I
However, there is more to Investment than just
spending on producer goods. There are two types:
Intended (or Planned) Investment
is the spending on plant, machinery, research and development that
firms do in an effort to increase their productive capacity (and
therefore their revenue) in the future.
R
Unplanned Investment (a change in stocks)
occurs when firms over-produce and have surplus stock left unsold.
This unsold stock acts like Investment as it will generate revenue
when it is sold at a future date. It also has an impact on the
production levels of firms as they react to lower than expected sales.
Both of these kinds of investment must be counted, and enable further
analysis of the economy to occur. The new equation for GDP reads:
C + I + R
Re-cap
GDP = Y (income)
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Savings
GDP = C + S (savings)
Investment
FINANCIAL SECTOR
GDP = C + I (investment)
GDP = C + I + R
The Sectors in Detail
What determines the level of:
• Consumer Spending?
• Planned Investment?
• Unplanned Investment?
Consumer
Spending
The main determinant of consumer spending is
level of income, but it is not as simple as that.
There are in fact two types of consumer
expenditure:
Autonomous Consumption
Induced Consumption
refers to a basic level of
expenditure on necessities such as
food and electricity. This type of
spending is constant and does not
change as income rises or falls.
is directly related to the level of income.
More income induces more spending, but
Saving will also increase as income rises.
The percentage of income that is spent can
be expressed as a decimal and is called the
marginal propensity to consume.
C = a + ccY
So, Consumption equals autonomous spending plus a percentage of Income
This equation is called the Consumption Function
Consumer
Spending
Here is a simple example of how the
Consumption Function works.
Let’s say that autonomous consumption = $40m,
And in addition, consumers tend to spend 80% of their income,
so the marginal propensity to consume = 0.8
Remember the consumption function is:
C = a + cY
If Income (Y)
equals . . .
autonomous
spending
equals . . .
$100m
40m
$200m
40m
$300m
$400m
induced
spending will
be . . .
So
Consumption
will equal . . .
80m
40 + 80 =
120m
0.8 x 200m =
160m
40 + 160 =
200m
40m
0.8 x 300m =
240m
40 + 240 =
280m
40m
0.8 x 400m =
320m
40 + 320 =
360m
0.8 x 100m =
Consumer
Spending
Consumers use income in two ways, they either
spend or save. Hence, we can get the equation:
Y=C+S
In that previous example, spending was sometimes greater than income. The
difference between income and spending is saving (called dis-saving if
negative). We will continue to use the same example.
As shown in the last slide . . .
If Y = $400m, C will be $360m.
This means that savings (S) will be $40m.
If Y = $300m, C will be $280m.
This means that savings (S) will be $20m.
If Y = $200m, C will be $200m.
This means that there will be no savings.
If Y = $100m, C will be $120m.
This means that savings (S) will be -$20m.
Planned
Investment
As previously studied, Planned Investment (or
Intended Investment) is spending by firms on
plant, machinery, research and development.
Unlike Consumption, Planned Investment is not primarily determined by the
level of income. Businesses base their investment plans upon a number of
factors:
• the expected return: the investment is likely to increase profits by
more than the (interest) cost of the investment.
• prevailing interest rates: lower interest rates make a greater range
of investment projects worthwhile.
• economic outlook: if the economy is expected to grow, profit forecasts will be good so investment will be less risky.
• the size of the economy: the larger the economy, the more likely that
it gain can economies of scale. This will provide funds for
re-investment, especially in research and development.
Unplanned
Investment
Otherwise known as the Change on Stocks,
Unplanned Investment is an important indicator
that the economy responds to.
We’ll further develop an earlier example to show the impact of
Unplanned Investment on an economy.
If: Autonomous Consumption = $40m
Induced Consumption = 0.8Y
and Planned Investment = $20m
We will be using the following equations:
C = 40 + 0.8Y
For example:
Y = C + I + R
and
Y=C+S
if Y = $500m
C will be 40 + 0.8(500) = $440m
So for these equations: Y = C + I + R
Y= C +S
500 = 440 + 20 + R
500 = 440 + S
So R = $40m
So S = $60m
Unplanned
Investment
Using these equations and figures, we can
complete the table as follows:
C
500
=
=
400
R
S
40
60
+
20
40
20
+
0
20
20
+
-20
0
I
440
+
+
20
+
+
=
360
+
20
300
=
280
+
200
=
200
+
Y
levels are
are rising,
still
If Stock
stock levels
rising,
so firms
will
then
firms
have overcontinue
to cut and
estimated
demand
production.
There will
be
will cut production.
The
further
in GDP
resultdecreases
is a decrease
in
(income
willwill
fall).
GDP
(income
fall).
If stock levels are falling,
then firms have underestimated demand and will
increase production. The
result is an increase in GDP
(income will rise).
Unplanned
Investment
500
=
=
400
Using these equations and figures, we can
complete the table as follows:
R
S
40
60
+
20
40
20
+
0
20
20
+
-20
0
440
+
+
20
+
+
=
360
+
20
300
=
280
+
200
=
200
+
Y
C
I
Changes in Stock Levels will cause the economy to seek an equilibrium where
R = 0
You will notice that at this level of income (GDP)
Savings (S) = Investment (I)
so
Withdrawals = Injections
Unplanned
Investment
And so to summarise:
Income
FIRMS
HOUSEHOLDS
Consumption Spending
Savings
Investment
An Economy will be in EQUILIBRIUM if . . .
. . . what’s going out . . .
equals
. . . what’s coming in.