Lecture outline- 11- CIRCULAR FLOW OF INCOME

The Economy
Two-Sector Economy
We stuie the o!er"tion o# " two $sector in eterminin% out!ut "n income
etermin"tion o# " hy!othetic"l economy& The two sectors "re the 'usiness (#irm)
sector "n the househol sectors& It is " !rimiti*e ty!e o# "n economy& I# "ll income
is s!ent 'y the househol+ which #orms the "%%re%"te e,!eniture o# the system& The
"%%re%"te e,!eniture #orms the "%%re%"te em"n in the system& In economics+
"%%re%"te em"n is the tot"l em"n #or #in"l %oos "n ser*ices in the economy
(-) "t " %i*en time "n !rice le*el& It is the "mount o# %oos "n ser*ices in the
economy th"t will 'e !urch"se "t "ll !ossi'le !rice le*els& This is the em"n #or
Firms
.o*t&
/ousehols C"!it"l
m"r0et
Forei%n
sector
.o*t& !urch"ses 1 su'siies (.)
2irect 1 inirect T", (T)
W"%es 1 s"l"ries 1 tr"ns#er
!"yments (.)
2irect T",es (T)
3"yments #or Im!orts (M)
Recei!ts #rom e,!orts (4)
E,!ort o# m"n!ower
Forei%n remitt"nce
Consumer e,!eniture
F"ctor !"yments
the %ross omestic !rouct o# " country& It is o#ten c"lle e##ecti*e em"n or
"''re*i"te "s 5A25&
Thus in this economy "%%re%"te em"n com!rises the tot"l e,!eniture m"e 'y
househols #or !urch"sin% %oos "n ser*ices !rouce 'y the #irm sector& Th"t is
the "%%re%"te su!!ly o# the economy& When "%%re%"te em"n is e6u"l to "%%re%"te
su!!ly+ the economy is in e6uili'rium& A27AS
Let us "ssume th"t the househols now ecie to s"*e " !ortion o# their income& We
s"w in the i"%r"m th"t this "mount is le"*in% the circul"r #low& The s"*in%s "re
tre"te "s le"0"%es in the system& It le*ies the circul"r #low& In this two sector moel
we tre"t s"*in% is the only le"0"%e&
Su!!osin% this "mount o# s"*in%s %oes to the #in"nci"l system o# the country& I#
in*estors 'orrow #in"nci"l c"!it"l #rom the #in"nci"l system o# the economy+ "n i#
"ll "mount th"t is s"*e now is em"ne 'y the in*estors "n in*est them in the
economy in !hysic"l c"!it"l there is " ch"n%e in the "%%re%"te em"n&
In*estors s!en this 'orrowe money in !urch"sin% c"!it"l %oos+ 'uilin%s+
e6ui!ments+ m"chinery to use in !rouction& This money "s to the #low o#
"%%re%"te em"n in the system& It is "n IN8ECTION9
Now there "re two ty!es o# com!onents in "%%re%"te em"n9
A2 7 C : I
C9 Consum!tion e,!eniture incurre 'y the househols
I9 In*estment e,!eniture incurre 'y the In*estors in the system&
Simil"rly+ there "re two ty!es o# items "re !rouce in the system+ Consumer %oos
"n in*estment %oos&
AS7 C : I
When the "%%re%"te em"n is e6u"l to "%%re%"te su!!ly this economy is "%"in in
e6uili'rium&
AS9 -7 A2
(1) -7 C: I
Or+
I# le"0"%es "re e6u"l to in;ections still the economy 'e in e6uili'rium&
(<) S 7 I
Three-Sector Economy
Let us " the %o*ernment sector to this economy& This is still " close economy&
.o*ernment h"s " role in the economy& It h"s to !ro*ie !u'lic %oos "n semi-
!u'lic %oos to the system& 3u'lic %oo is " %oo th"t is non-ri*"le "n non-
e,clu"'le& This me"ns th"t consum!tion o# the %oo 'y one ini*iu"l oes not
reuce "*"il"'ility o# the %oo #or consum!tion 'y others= "n th"t no one c"n 'e
e##ecti*ely e,clue #rom usin% the %oo& .o*ernment nees money #or the
!ro*ision o# these !u'lic %oos& It im!oses t",es+ irect "n inirect+ on the
househols to collect re*enue #or %o*ernment e,!enses&
When %o*ernment im!oses " irect t", on the househol sector+ the househols h"*e
no other choice th"n !"yment o# th"t t", #rom their income& It is the l"w>
This "mount o# money le"*es the system "n it is " le"0"%e& Uner three-sector
economy there "re two ty!es o# le"0"%es in the system+ s"*in%s "n t",&
Le"0"%es9 S : T
The circul"r #low o# income shrin0s to the e,tent o# the le"0"%es& We le"rnt 'e#ore
th"t this c"uses contr"ction e##ects on the system& A%%re%"te em"n is less th"n
"%%re%"te su!!ly& 3rices #"ll+ !ro#it m"r%ins ro!+ !ri*"te sector is iscour"%e+
curt"ilin% the !rouction+ wor0ers "re s"c0e+ unem!loyment+ low income&
The economy will 'e in e6uili'rium "t " lower le*el+ e*entu"lly&
Assume th"t now the %o*ernment s!ens "ll t", income in the economy9
Then the income th"t le#t the #low ue to t", is comin% '"c0 into the system throu%h
" i##erent source&
The %o*ernment s!ens on e#ense+ security+ merit %oos li0e he"lth "n euc"tion
which money %oes to the h"ns o# the !eo!le who s!ens th"t money in the m"r0et&
As " result the "%%re%"te em"n "%"in %oes u!&
There "re three com!onents in the "%%re%"te em"n9
3ri*"te consum!tion e,!eniture+ !ri*"te in*estment e,!eniture "n %o*ernment
e,!eniture&
A27 C : I : .
AS7 CONSUM3TION .OO2S : IN?ESTMENT .OO2S : 3U@LIC .OO2S :
SEMI-3U@LIC .OO2S
Now the le"0"%es "re e6u"l to in;ections in this system once "%"in&
S : T 7 I : .
These "re e,o%enously etermine9
This economy will 'e in e6uili'rium&
2i##erence is th"t !re*iously the 'unle o# %oos "n ser*ices com!rise o# !ri*"te
%oos "n ser*ices 'ut now the 'unle com!rises !ri*"te %oos "n !u'lic %oos&
3ri*"te %oos !rouce 'y the system "re less th"n th"t o# !re*ious !rouction&
I# !l"nne S : TA I : .B
Then tot"l le"0"%es "re %re"ter th"n tot"l in;ections& The economy %oes throu%h "
!rocess o# contr"ction settlin% "t " lower le*el o# e6uili'rium&
I# !l"nne S : T C I : .B
Then in;ections "re %re"ter th"n le"0"%es& The economy %oes throu%h " !rocess o#
e,!"nsion settlin% "t " hi%her le*el o# e6uili'rium&
Four-sector Economy
An o!en Economy
O!en economy "llows tr"ns"ctions with the rest o# the worl& /ousehols c"n
im!ort the thin%s wh"t they w"nt "n #irm sector c"n im!ort their nees+ they c"n
e,!ort their !roucts to the rest o# the worl&
When househols "n #irms im!ort thin%s (M) #rom "'ro"+ income #lows out& It is
" le"0"%e #rom the circul"r #low o# income&
When the #irms e,!ort thin%s to the rest o# the worl (4) it is "n in;ection o# income
into the circul"r #low o# income&
Uner o!en economy TOTAL LEADA.ES "re9
S : T : M
TOTAL IN8ECTIONS "re9
I: . : 4
When tot"l le"0"%es "re e6u"l to tot"l in;ections9
S : T : M 7 I: . : 4
Economy will 'e in e6uili'rium&
S : T : M A I: . : 4
This le"s to " contr"ction&
S : T : M C I: . : 4
This le"s to "n e,!"nsion&
The A%%re%"te em"n in this economy is9
A29 C : I : . : 4
AS9 C : I : . : M
- : M 7 C : I : . : 4
Or+
- 7 C : I : . : (4- M)
Deynesi"n Economics
DeynesEs consum!tion #unction
C 7 # (-)
C 7 " : ' -
When income is Fero !eo!le still consume usin% their s"*in%s&
Let us "ssume th"t the Consum!tion #unction t"0es the #ollowin% #orm9
TWO- SECTOR ECONOM-
C7 1GG : G&HI -
I7 <GG
- 7 C : I
- 7 1GG : G&HI - : <GG
- $ G&HI - 7 1GG:<GG
- (1 - G&HI) 7 JGG
1200
1
4
* 300
4
1
300
0.25
300
0.75) (1
300
Y = = = =

=
C 7 1GG : G&HI (1<GG) 7 1GGG
S 7 - $ C
S 7 -- (1GG : G&HI -)
S 7 - $ 1GG $ G&HI -
7 -1GG :- $ G&HI -
S 7 - 1GG : G&<I -
S 7 1<GG $ 1GGG 7 <GG
In this economy S 7 I "n is in e6uili'rium&
S 7 <GG "n I 7 <GG
<GG
KGG
LGG
MGG
1GGG
1<GG
1KGG
1LGG
1MGG
<GGG
<<GG
A
%
%
r
e
%
"
t
e

e
,
!
e
n

i
t
u
r
e
<GG KGG LGG MGG 1GGG 1<GG 1KGG 1LGG 1MGG <GGG <<GG
N"tion"l Income 7 N"tion"l out!ut 7-
C7 1GG : G&HI -
S7 I 7<GG
C7 1GG : G&HI - : <GG
-1GG
S
-I
0
45
T/REE SECTOR MO2EL
- 7 C : I : .
C7 1GG : G&HI -
I7 <GG
. 7 JGG
- 7 - $ T
T 7 t -
I# t7 <G N
- 7 - $ G&< -
- 7 C : I : .
- 7 1GG : G&HI (- $ G&<-) : <GG : JGG
- 7 1GG : G&HI- $ G&1I- : <GG : JGG
- $ G&HI - : G&1I -7 1GG:<GG :JGG
- (1 - G&HI : G&1I) 7 LGG
1500
2
5
* 0 60
4
10
* 600
10
4
600
0.4
600
0.15) 0.75 (1
600
Y = = = = =
+
=
C 7 1GG : G&HI (1<GG $ G&<-) 7 1GGG
S 7 - $ C
S 7 (-- G&<-) - (1GG : G&L -)
S 7 G&M- $ (1GG : G&L -)
7 -1GG :G&M- $ G&L -
S 7 - 1GG : G&< -
S 7 -1GG :G&< (1IGG) 7 <GG
T 7 G&< -
T 7 G&< (1IGG) 7 JGG
LEADA.ES 7 IN8ECTIONS
S : T 7 I : .
<GG : JGG 7 <GG : JGG
<GG
KGG
LGG
MGG
1GGG
1<GG
1KGG
1LGG
1MGG
<GGG
<<GG
A
%
%
r
e
%
"
t
e

e
,
!
e
n

i
t
u
r
e
<GG KGG LGG MGG 1GGG 1<GG 1KGG 1LGG 1MGG <GGG <<GG
-
C7 1GG : G&L -
S : T7 I : .
7<GG
C7 1GG : G&L - : <GG :JGG
-<GG
S 7 -1GG :G&< -
T 7 G&<-
0
45