How the macroeconomy works

1. How the macroeconomy works The Circular Flow of Income

2. http://www.tutor2u.net/economics/reference/circular-flow-of-income-and-spendinghttp://www.tutor2u.net/economics/reference/circular-flow-of-income-and-spending

3. The circular flow of Income (The Four Sector Model) Injections Withdrawals A simple economic model which describes the reciprocal circulation of income between producers and consumers Households S + T + M G + X Payment Of factors £10m Payment for goods and services £10m Firms Injections Withdrawals I +G + X S + T + M

4. Households & Firms The Two Sector Model

5. Households and Firms (two sector economy) • A model where by firms hire the four factors of production from households to produce goods and services and in return for their work are paid in the form of rent, wages, interest and profit. • The flow of money and income is circular as: • The income earned by households allows them to buy the goods and services that are sold by the firms • The firms use the factors of production to produce goods and services • Households buy the good and services with money they have earned working for the firms • The money passes from firms and then back again.

6. The Circular Flow of Income • The flow of money and income is circular as: • The income earned by households allows them to buy the goods and services that are sold by the firms • The firms use the factors of production to produce goods and services • Households buy the good and services with money they have earned working for the firms • The money passes from firms and then back again. Households Payment Of factors £10m Payment for goods and services £10m Firms

7. Equilibrium • An economy is said to be in equilibrium when the amount factors are paid is all spent on the good and services produces by domestic firms. • In the above example:- Payment Of factors £10m (firms) Payment for goods and services £10m (households)

8. disequilibrium • In reality households do not spend all of their income on products and firms do not spend all their revenue hiring labour

9. Withdrawals/Leakages from the circular flow Withdrawals • Any money not passed on in the circular flow. • Household savings • Firms retained profit. • Withdrawals have the effect of reducing national income/output/expenditure Households S Payment Of factors £10m Payment for goods and services £10m Firms Withdrawals S

10. Disequilibrium – households saving a percentage of their income Payment for goods and services £9m (households) Payment Of factors £10m (firms) The reduction of payments for services causes a contraction of the economy. Equilibrium may be restored by firms reducing payment for factors (reduced wages, production and or unemployment ). National income/output/expenditure is now only £9m

11. Disequilibrium – firms retaining profit for the future Payment Of factors £9m (firms) Payment for goods and services £10m (households) The reduction in payments for factors causes a contraction of the economy. Equilibrium is likely to be restored by households spending less, a result of reduced wages, production and or unemployment. National income/output/expenditure is now only £9m

12. Injections to the circular flow • Money that originates outside the circular flow. • Firms undertaking investment spending from retained profit of borrowed funds. • Injections have the effect of increasing national income /output/expenditure Households Payment Of factors £10m Payment for goods and services £10m Firms Injections I

13. Disequilibrium – firms undertaking investment spending Payment for goods and services £10m (households) Payment Of factors £11m (firms) An increase in the payment for factors causes an expansion of the economy. Equilibrium may be restored by households increasing payment for goods and services (increased wages, production and or employment ). National income/output/expenditure is now £11m

14. Government Expenditure & Taxation The Three Sector Model

15. Injections to the circular flow(government spending) Injections • G regarded as an injection as it does not arise through spending of households. • G may benefit households employed by the public sector (more employment or higher wages) or through transfer payments. • G may benefit firms through the winning of contracts or grants and subsidies. Households G Payment Of factors £10m Payment for goods and services £10m Firms Injections I + G

16. Disequilibrium – governments undertaking spending on new house building projects Payment for goods and services £10m (households) Payment Of factors £11m (firms) An increase in the payment of factors causes an expansion of the economy. Equilibrium may be restored by households increasing payment for goods and services (increased wages, production and or employment ). National income/output/expenditure is now £11m

17. Withdrawals/Leakages from the circular flow (government taxation) Withdrawals • T affects both households and firms. • T has the effect of reducing the amount both have to spend. • Important to understand the government’s net position or FISCAL STANCE i.e. does it plan to spend more than it receives in taxes? • The Budget delivered by the Chancellor of the Exchequer outlines the government’s plans regarding Taxation and spending for the forthcoming year. Households S + T Payment Of factors £10m Payment for goods and services £10m Firms Withdrawals S + T

18. Equilibrium (recap so far) • An economy is said to be in equilibrium when planned injections = planned withdrawals I + G S + T Where planned injections are greater than planned withdrawals, the effect on the circular flow is expansionary.

19. Exports & Imports The Four Sector Model (The open economy)

20. Injections to the circular flow (exports) Injections • X are considered an injection for they originate outside the circular flow. • They have the effect of increasing national income. Households G + X Payment Of factors £10m Payment for goods and services £10m Firms Injections I + G + X

21. Disequilibrium – an increase in demand for domestically produced goods/services abroad Payment Of factors £10m (firms) Payment for goods and services £11m (households) The increase in payment for goods and services abroad causes disequilibrium in the economy. Equilibrium is likely to be restored by an increase in the payment of factors a result of higher wages, production and or employment. National income/output/expenditure is now £11m

22. Withdrawals/Leakages from the circular flow (imports) Withdrawals • M represents money leaving the circular flow. Households S + T + M Payment Of factors £10m Payment for goods and services £10m Firms Withdrawals S + T + M

23. In summary • An economy is said to be in equilibrium when planned injections = planned withdrawals I + G + X S + T + M

24. Disequilibrium and the effect on the circular flow (national income) • An economy is said to be in disequilibrium when:- planned injections > planned withdrawals Or planned injections < planned withdrawals S + T + M I + G + X I + G + X S + T + M Contractionary effect on the circular flow (reduced national income) Expansionary effect on the circular flow (increased national income)

25. The circular flow of Income (The Four Sector Model) Injections Withdrawals A simple economic model which describes the reciprocal circulation of income between producers and consumers Households S + T + M G + X Payment Of factors £10m Payment for goods and services £10m Firms Injections Withdrawals I +G + X S + T + M