ECF01

FOUNDATION ECONOMICS
SEMESTER 2, 2006
 UNIT 13
CIRCULAR FLOW OF INCOME
and SPENDING
 Lecture Outline
• National Income and National Output
• The Circular Flow Model
• The Two Sector Model – Simple and Complex
• Injections and Withdrawals (Leakages)
• The Three Sector Model
• The Four Sector Model
• Nominal GDP and Real GDP
• Index Numbers
• The Equation of Exchange
National Income and National Output
 In units 1 -12 our focus was on micro-economic issues
 However, from this unit 13 until the end of this course our
discussion will be focusing on macro-economics
 That is, discussion of issues related to the welfare of the
whole economy or the national economy
 A key issue in macro-economics is the measurement of
national income and national output
 National Income and National Output are simply define as
follow:
– national income – total amount of money generated by an economy
in a period of time (usually a year)
– national output – total monetary value of goods and services
produced by an economy in a period time (usually a year)
 National Income and National Output
 To understand well how national income and national
output is measured must study or analyse the
relationships between different sectors of the economy
 Two types of economy
1) close economy – no international trade
2) open economy – there is international trade
 A close economy has three sectors:
i. Households – individuals (i.e. consumers/labourers - owners of
resources)
ii. Firms – businesses (i.e., sellers/ employers/producers – users of
resources)
iii. Government – law & order, tax and provider of collective goods
and services
 National Income and National Output

 An open economy has four sectors:

i. Households
ii. Firms
iii. Government
iv. Foreign Sector

 The relationship between these sectors are used to

measure national income and national output
 The Circular Flow Model
 The relationship between the different sectors in an
economy is better understood by the using of a circular
flow model
 A Circular Flow Model
– shows the relationship between different sectors of an economy

 Different circular flow models discussed in this course are:

1) Two sector model – households and firms
2) Three sector model – households, firms and government
3) Four sector model – households, firms, government and the
foreign sector
 Two Sector Model
 A two sector model can be a simple or a complex one

3) The simple circular flow model

 Shows money flows and real flows between households
and firms
• Households – the owner of resources – land, labour, capital and
enterprise (inputs or factors of production)
• Firms – the users of resources (producing goods and services)
 The Simple Circular Flow Model
 Money flows:
– from households to firms in the consumption of goods and services
– from firms to households to pay wages, rents or profits (factor
reward/income)
 Real Flows:
– goods and services supplied by firms to households
– economic resources of land, capital and labour (factor inputs)
supplied by households to firms
 The Simple Circular Flow Model
 Under the simple two sector model we assume that:
– all money earned (income) by households are used in consumption
– to buy goods and services
– all money earned by firms are used to produce goods and services
– households consumption ( C) = Firms spending or expenditure (E)

 Must able to differentiate between money and income

– Money – a stock of dollars at a certain point in time and is
sometimes referred to as the money supply
– Income – a flow generated as money travels around the circular
flow. Involves velocity of circulation.
– Velocity of circulation – the number of times one unit of money
circulates in the circular flow in a given time
 The Simple Circular Flow Model
 For example – velocity of circulation
– if on average each dollar travels 5 times from Households to Firms
and back in one year, then each dollar generates $5 of income and
output for this economy.
– therefore velocity of circulation is equal to 5

 Measurement of National Income and Output under a

Simple Two Sector Flow Model
– National Income – total national income generated in a period
– National output – also known as the Gross Domestic Product
(GDP). Total money value of all goods and services produced in a
period
 The Simple Circular Flow Model
 Under a simple two sector flow model:
– all money received by Firms are used in producing goods and
services
– all money received by Households are consumed or used to buy
goods and services

 Due to the above assumptions, therefore the value of:

– the National output (GDP) - is the total amount obtained by the

Firms when producing goods and services

– the National income (NI) - is the total amount earned by

Households from factor inputs
 The Simple Circular Flow Model
 Example – National Output
 Consider a very simple economy that produces cassava
and taro
 Production:
– cassava: 20 thousands tons, sold at $400 per ton
– taro: 30 thousands tons, sold at $500 per ton

– National output (GDP) = expenditure on cassava + expenditure on

taro
– = ( $400 x 20 000) + ($500 x 30 000)
– = $8 m + $15m
– = $23 million
– Thus, the national output is $23million
 The Simple Circular Flow Model
 Example – National Income
 Assume that $16 million is paid to workers who produce
cassava and taro
 The difference between the revenue from sales and costs
of productions or wages is called operating surplus

 Operating surplus – profits which may be paid out as

dividends or as income to entrepreneurs
– Operating surplus = revenue – costs
= $23 m - $16m
= $7m
 The Simple Circular Flow Model
 Households as workers receive income in the form of
wages and owners of capital or as entrepreneurs they
receive profits

 Thus, the National Income is:

= wages + dividends (profits)
= $16 m + $7m
= $23m

 Conclusion:
 National Output (GDP) equals National Income
$23m = $23 m
value of national output = income earned by households
(wages +profits)
 The Simple Circular Flow Model
A – factors of production

B – factor reward/income
(wages, profit, rent etc)

HOUSEHOLDS FIRMS

C – goods and services

D – payments for goods and services

Money flows – B & D National Output (GDP) – measured using flow D

($23m –from example)
Real flows – A & C National Income – measured using flow B ($23m
from example)
 The Simple Circular Flow Model
 Points to note:
 People produce output and are paid income for producing
output
 People then buy the output from the firms (national
expenditure)
 The value of output (national output) must equal to the value
of incomes earned (national income)
 Therefore the following equilibrium holds:

NATIONAL OUTPUT (GDP) = NATIONAL INCOME = NATIONAL EXPENDITURE

 Two Sector Model – Complex Circular
Flow Model
 Now, assume that Households can save part of their
income earned
 And the Firms changed the composition of output by
making consumer goods and capital goods (investments)
– consumer goods – commodities that satisfy consumer’s immediate
needs
– capital goods – long lived man-made resources that are used to
produce consumer goods. Also known as investment goods
 Because of these changes there is injections into the
circular flow and withdrawals from the circular flow
 Injections and Withdrawals
 Withdrawals – amounts taken out of the circular flow
 Example of withdrawals for now is savings by Household
 Savings (S):
• amount set aside by Households for future consumption
• reasons for savings include:
– an emergency
– retirement
– future purchase of consumer goods
– future expenses
 Households can save their money at home or more
commonly nowadays in the bank
 Injections and Withdrawals
 Since the amounts saved are not used in consumption
these amounts are not put back to the circular spending
flow, therefore savings is regarded as a withdrawal from
the circular flow

 Injections – amounts put back into the circular flow

 Example of injections for now is investments (capital
creation)
 Investments (I):
– buying of new or additional plants and machineries (new
investment)
– replacing of worn out capital (replacement investment)
 Injections and Withdrawals
 Assumption
 Injections always equals Withdrawals
 Why?
 Assume for now that the money saved by households in
the bank are borrowed by producers solely for the purpose
of investments or capital creation
 That is the Households save (S) and the Firms invest (I)
 Injections and Withdrawals
 Problem:
 If the Households loan direct to Firms in the forms of
buying of shares then no problem with our assumption
above
 But in reality, Households can deposit their money in the
bank or sometimes save it in a safety box at home
 This causes problems especially if the banks may not lend
all money to firms
 Also savings and investments are done by different people
 Thus planned savings may not always equal planned
investment
 Injections and Withdrawals
 For example:
 If savings higher than investments , this will result in:
– not all goods produced are consumed, unplanned stock results in
piling up of unsold goods (inventories)
– firms cannot sell all their goods and cut back production
– workers may lose their jobs and income fall
– as income fall, savings fall

 Therefore for equilibrium to exist (injections = withdrawals)

 The following conditions are assumed:
1) Investment is exogenous (fixed or does not depend on income)
2) Savings are a constant percentage of income
 Injections and Withdrawals
 In equation format:
 Let Y = national output = national income
 National output (Y) = the sum of consumption goods +
investment goods (I) + changes
in stocks (unplanned
investment) (ΔR)

 Thus: output is Y = C + I + ΔR (1)

 National Income (Y) = consumptions (C) + savings (S)

 Thus: income is Y = C + S (2)

 Injections and Withdrawals
 Assume price is constant and other values are in real
terms
 Then output = income, implies that:
C + I + ΔR = C + S, follows that:

I + ΔR = S, and if ΔR = 0, then it follows that:

I = S (3) - this is always true, as long as ΔR is zero

 That is planned investment (I) = planned savings (S)

 Two Sector Model – Complex Circular
Withdrawal
Flow Model
Producers
Investments (I) Injection
Banks

Equation:
Savings (S) Consumption –
consumer spending (C) Output = income
I + ΔR +C = C + S
I + ΔR = S
Households Firms
If ΔR =0, then
Factor income – wages, I = S (3)
profits etc (Y)

As long as there is no unplanned investments (ΔR = 0), and given everything else remains the
same (ceteris paribus) withdrawals always equal injections
That is planned savings (S) (withdrawals) = planned investments ( I )(injections)
 Three Sector Model – Government
Include in Circular Flow
 In a three sector model the Government sector is included
as part of the circular flow model
 How does the Government affect the equilibrium in the
circular flow model?
1) Withdraw amounts from the circular flow through taxes (T) –
transfer payments
2) Inject amounts into the circular flow through government
purchases - expenditure
 These Government actions affect both Households and
Firms
 Three Sector Model – Government
Include in Circular Flow
 Points to note:
 Taxes gain by Government is the net of taxes after
transfers has been deducted
 That is: Net taxes = T = Taxes – Transfer payments
 Why transfer payments are not included in government
purchases?
– transfer payments do not require that the recipient produce a good
or service in order to receive them
– examples of transfers payments include social security, welfare,
and unemployment benefits
– these are regarded as compensation and are not counted in
government purchases
 Three Sector Model – Government
Include in Circular Flow
 Points to note:
 Transfer payments and government purchases are both
parts of government spending

 But government purchases are represented on a circular

flow diagram as flows of money from government to firms
and goods and services from firms to government

 Government Purchases - are the sum of purchases of

goods and services from firms by government agencies,
plus the total value of output produced by government
agencies
 Three Sector Model – Government
Include in Circular Flow
 The Government sector is now included in the circular flow
model but the equilibrium condition of withdrawals =
injections remains (i.e., income = output)

 Thus equation (1) & (2) are extended to include

Government purchases (G) and Government net taxes (T)

 Output: Y = C + I + ΔR + G (Injections) (4)

 Income: Y = C + S + T (Withdrawals) (5)

 Three Sector Model – Government
Include in Circular Flow
 And since Output = Income, and with further manipulations
and assuming ΔR is zero we arrive at the following
equation (6)

 S + T = I + G (6) (withdrawals = injections)

 Three Sector Model – Government
Withdrawal
Include in Circular Flow
Producers
Investments (I) Injection
Banks
Consumption –
consumer spending (C)
Equation:
Savings (S) Output = income
Purchases/spending (G) Injections = withdrawals
I + ΔR +C+ G = C + S +T

Households Government Firms I + ΔR + G = S + T

If ΔR =0, then
I + G = S + T (6)
Transfers Taxes
(Net taxes (T))

withdrawal
Factor income – wages,
profits etc (Y)
 Four Sector Model – Foreign Sector
Include in Circular Flow
 In a four sector model the Foreign sector is included as part
of the circular flow model

 How does the Foreign sector affect the equilibrium in the

circular flow model?
1) Withdraw amounts from the circular flow through import payments (M)
2) Inject amounts into the circular flow through export receipts (X)
 Four Sector Model – Foreign Sector
Include in Circular Flow
 The Foreign sector is now included in the circular flow
model but the equilibrium condition of withdrawals =
injections remains (i.e., income = output)

 Thus equation (4) & (5) are extended to include Export

receipts (X) and import payments (M)

 Output: Y = C + I + ΔR + G + X (Injections) (7)

 Income: Y = C + S + T + M (Withdrawals) (8)

 Four Sector Model – Foreign Sector
Include in Circular Flow
 And since Output = Income, and with further manipulations
and assuming ΔR is zero we arrive at the following
equation (9)

 S + T + M = I + G + X (9) (withdrawals = injections)

 Four Sector Model – Foreign Sector
Include in Circular Flow
Withdrawal
Producers
Investments (I) Injection
Banks
Consumption – consumer
spending (C)
Export receipts (X)
Savings (S)
Purchases/spending (G)

Foreign
Households Government Firms
Sector
Equation:
Output = income Transfers Taxes Import payments (M)
Injections = withdrawals
I + ΔR +C+ G + X = C + S +T + M
(Net taxes (T))
I + ΔR + G + X = S + T + M
If ΔR =0, then
withdrawal
I + G + M = S + T + X (9)
Factor income – wages, profits
etc (Y)
 Nominal GDP and Real GDP
 The most common measure of National output (Y) is the Gross
Domestic Product (GDP)
 GDP – total number of goods and services a country produced in a
year
 GDP has two values:
4) Nominal GDP
– the current market value of national output in a year
– not yet adjusted for price changes

6) Real GDP
– the value of national output adjusted for changes in price level or in fact
adjusted for inflation
– nominal values are corrected (deflated) using price index numbers
– because of the above reason Real GDP is a better measure of national
output than Nominal GDP
 Nominal GDP and Real GDP
 Real GDP is usually calculated by:

Real GDP (base year dollars) = Nominal GDP x Base Year Price Index
Price Index
• Base year – a year chosen as a standard of measurement of price
• Base year price index are usually expressed in 100 or 1000
• This formula is only used if the price index numbers are given
 Example
• If the Nominal GDP for Fiji in 2005 is $20m, base year is 2000, and the
price index for Fiji in 2005 is 1450
• Then Fiji’s Real GDP for 2005 in 2000 prices is:
= $20m x 1000
1450 1
= $13.8m
 Nominal GDP and Real GDP

 Nominal/Real GDP per capita

• the GDP values divided by population number
• For example
• If the population of Fiji in 2005 is 1 million people, and the nominal
GDP is $200m, the nominal GDP per capita is:
= $ 200,000,000
1,000, 000
= $200 per capita

 Real GDP per capita – the nominal GDP value must be

adjusted for price changes
 Comparison of Nominal and Real GDP
 A more direct approach to the calculation of Nominal GDP and Real GDP is
given in the example below

 Example:
 Nomuka, a hypothetical island in the South Pacific produces two items as
shown in the table below
• Calculate the value of the Nominal GDP and Real GDP in 1999 and 2002.
Comment on your results.

Items 1999(Base) 2002 (Current)

Qty (kg) Price Qty (kg) Price

($/kg) ($/kg)
Item A 3000 2.50 3500 3.00
Item B 3200 3.40 3300 3.60
Nominal and Real GDP - Calculation and
Comparison
 Nominal GDP:
 Current Year Price x Current Year Qty
1999:
Item A: 3000 x $2.50 = $7500
Item B: 3200 x $3.40 = $10880
= $18,380
2002
Item A: 3500 x $3.00 = $10500
Item B: 3300 x $3.60 = $11880
= $22380
 Increase in GDP is due to increase in
price level (check with same quantity
and different prices)
 Real GDP:
 Base Year Price x Current Year Qty
1999:
Item A: 3000 x $2.50 = $7500
Item B: 3200 x $3.40 = $10880
= $18,380
2002
Item A: 3500 x $2.50 = $8750
Item B: 3300 x $3.40 = $11880
= $19970
 Increase in GDP is due to increase in the
number of goods and services produced
 The increase in Real GDP is the one
economists interested in
 Index Numbers
 Shows the change of prices from year to year of a given basket of
commodities
 Basket of commodities – items with the same nature put together
• Egs – A Food basket: consists of taro, rice , cassava etc
Home appliance basket: consists of fridges, stoves, microwaves etc
 Different values of each commodities included in the basket, are
weighted according to amount spend on them
 Commonly used price indexes are:
1) Consumer Price Index (CPI)
– use to measure the changes in the prices of goods typically bought by
consumers

• Read and do the student activity on page 231 of Study Guide on how to
calculate the CPI
 Index Numbers
1) Producers Price Index (PPI)
– measures changes in input and output prices of goods bough and
sold by producers
2) GDP Deflator
– an implicit index used to calculate the Real GDP

3) Other Price Indexes:

i. Export and Import Price Indexes
– measure changes in export and import prices
ii. Wage rate index
– measure movements in wages
iii. Real disposal indexes
– measure changes in spending power of individual
 The Equation of Exchange
 Shows the relationship between the money stock and its
velocity of circulation
 Express in the following equation format:
MV = PY
• where:
– M = money stock or money supply
– V = velocity of circulation
– P = general price level expressed as an index number, and
– Y = national output (Real GDP)
END OF UNIT 13