2. Circular Flow of Economic Activities and
Income
The simple model of the circular flow assumes two players
Firms
• Produce and supply the goods and services.
• Require various factors of production to produce these
goods and services.
Households
• Take joint decision about the consumption of goods and
services.
• Provide services in terms of factor inputs to the firms
• Get paid for these services by firms which households
spend on consumption.
• Money flows from firms to households as factor payments and from
households to firms as expenditure on goods and services.
• It is a circular flow of money or income
3. Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs
Households
Savings
(S)
Financial
Market
Investment
(I)
Firms
Goods and
Services (O)
Consumption
expenditure
(C)
In the equilibrium Y=C+S=C+I=E=O
4. Circular Flow of Economic Activities
and Income
•
•
•
•
•
•
•
•
Value of output produced (Y) = value of output sold (O)
Value of output sold = Sum of consumption expenditure (C) and
investment expenditure (I).
Y=O=C+I=E……(1)
Income is either consumed or saved (S).
Y=C+S………….(2)
C+I=Y=C+S………(3)
Therefore:
I = S…………(4)
Savings are withdrawal of money from the circular flow
Investment is injection of money into the circular flow
For equilibrium savings should be equal to investments
Hence Y=O=E
5. Circular Flow of Income
(Four Sector Economy)
The third sector is Government (G)
•
Government Spending
–
–
–
•
On provision of public utility goods and services.
Provides salaries to the households
Pays to firms for purchases of goods and services
Government Revenue
–
–
Households and firms pay various taxes and other payments and
provide factor inputs to the government.
Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
•
•
Imports (M): Outflow of income occurs when the domestic firms buy
goods and services from foreign ones.
Exports (X): Inflow of income takes place when foreign firms buy
goods and services from domestic ones
6. Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxes
Taxes
Factor
Payments
Remittances
for purchases
Factor Inputs
Salaries
Households
Savings
(S)
Imports
(M)
Financial Market
Investment
(I)
Imports
(M)
Goods
(O)
Consumption
Expenditure
Exports
(X)
Foreign Nations
(X-M)
Firms
Exports
(X)
National Income=C+I+G+(X-M)
7. Circular Flow of Income
(Four Sector Economy)
• National income includes expenditures on consumption investment,
government and net of exports (X-M)
National Income=C+I+G+(X-M)
• Since national income can either be consumed, or saved, or paid as
tax to the government:
C+I+G+(X-M)=C+S+T
I+G+(X-M) =S+T
• Sum of private investment and expenditure on net exports is equal to
the sum of savings and tax revenue. Thus:
I+G+X =S+T+M
• Therefore,
W=J
• At equilibrium, total injections are equal to total withdrawals.
8. Aggregate Demand
• Sum of demand for all goods and services
by all consumers for a given period of time
may be termed as aggregate demand
• It is the total demand in terms of goods and
assets at a given price by all the people in
an economy.
• Thus it can be said that aggregate demand
refers to aggregate expenditure made by the
society as a whole.
9. Aggregate Demand
• Aggregate demand consists of two
components,
– aggregate demand (AD) for consumer goods
i.e. consumption demand (C)
– aggregate demand for capital goods i.e.
Investment demand (I).
Thus AD = C+I
10. Aggregate Supply
• Aggregate supply is the total national output
produced and supplied by all the factors of
production in an economy.
• It refers to the supply of all goods and services in
the economy for a given period of time.
• Aggregate supply (AS) consists of
– Aggregate supply of consumer goods (C) and
– Aggregate Supply capital goods (where capital comes
from savings) (S),
Hence AS=C+S
12. Stock and Flow
• The distinction between stock and flow usually
lies in the dimension of time.
• Stock may be defined as any economic variable
which has been accumulated at a specific point of
time
– like money, assets and wealth.
• Flow includes the variables which increase
(inflows) and decrease (outflows) the stock, over a
period of time.
– like income, consumption, saving and investment
13. Stock and Flow
Stock
Inflow
Outflow
Inventory
Incoming goods
Outgoing goods
Bank balance
Deposits
Withdrawals
Population
Births + immigration
Deaths + emigration
Money Supply
Income
Consumption +
investment
Mathematically a stock can be seen as an accumulation or
integration of flows over time, with outflows subtracted from
the stock.
Stock=Inflows-Outflows
14. Intermediate and Final Goods
• Intermediate goods (and services) are
items purchased by firms for using them in
production of some other good of utility.
• Also known as producer goods because
they are used as inputs in the production of
other goods.
– partly finished goods or raw material.
15. Intermediate and Final Goods
• Final goods are demanded by the final
consumer for using these goods as they are.
• Also known as consumer goods, as no
value addition is made beyond this stage.
– Durable, non durable, perishable goods
• The distinction is made for calculation of
national income where only final goods are
considered.
16. Capital Formation
• Capital formation is the enlargement of capital stock.
• The process of savings being converted into investment is
known as capital formation
• Investment: individual
• Capital formation: nation
• Gross private investment is business spending on
equipment, residential structures, and inventories; it is net
investment plus depreciation (or capital consumption
allowance).
• Gross Capital Formation refers to the aggregate of
additions to fixed assets (Fixed Capital Formation) and
increase in stocks of inventories during a period of time.
17. Capital Formation
• Rate of capital formation is the measure of growth of an
economy, because it determines the volume of investment
in future.
• The higher the rate of capital formation, higher is the
increase in production of goods and services and hence
higher is the economic growth of the economy.
Capital Formation in India (at 1999-2000 Prices)
2004-05
Gross Fixed Capital Formation
Change in Stocks
Rs. Crore
2005-06
2006-07
6,57,317
7,57,806
8,68,618
46,633
78,821
86,840
18. Government Revenue and
Expenditure
• Government Revenue:
income received by
government in various forms, including Direct and
Indirect Taxes and non- tax revenue.
• A direct tax is one paid directly to the government by
the persons on whom it is imposed
• An indirect tax is one where incidence is on one person
and impact is on someone else.
• Non tax revenue includes profits from investment, interest
earned on securities, etc.
19. Government Expenditure
• Government Expenditure
– Government Expenditure is which is made from public
exchequer.
– Includes transfer payments, which refers to payments made
to certain sections of the society as a social welfare
measure.
– It is an exchange of purchasing power from one group of
people to another.
– These include unemployment compensation, retirement
benefits, pensions, etc.
20. Employment
• An important macro variable that affects the
national economy.
• A person who is willing and capable to work in a
productive activity and is engaged for certain
number of hours per week, whether working for
self or someone else, is employed
• The population of any country is divided into
working population (age group of 16 to 65 ) and
dependents.
• Every country tries to achieve full employment so
that maximum economic growth with maximum
social welfare can be achieved.
21. Types of Unemployment
•
•
•
•
•
Involuntary unemployment : where people are capable to work and
willing to work at the prevailing wage rate but fail to get an
opportunity.
Voluntary unemployment : where a person is out of job because he
is either not willing to work on the prevalent or prescribed wages or
does not want to work at all.
Frictional Unemployment occurs when an individual is out of his
current job and looking for another job. This is purely temporary
phenomenon.
Structural Unemployment: occurs when there is a mismatch of skilled
workers in the labour market.
Classical Unemployment: occurs when trade unions and labor
organization bargain for higher wages, which leads to fall in the
demand for labour.
22. Types of Unemployment
• Cyclical unemployment is the result of the trade cycle. It
is also referred as Keynesian unemployment, or as
deficient-demand unemployment.
• Sudden unemployment occurs due to changes in the
work place conditions; this may be due to closure of the
firm, dispute between partners, etc.
• Seasonal unemployment occurs when certain industries
and traders engage workers for a particular season such
as Sugar industry, tourism and event management.
• Disguised unemployment is one where people appear to
be employed but when you remove some of them the
total produce remains same. Marginal productivity of
labour is zero in such case.
23. Consumption Function
• The aggregate consumption in any economy is the
summation of consumption expenditure by all the
individuals
• Marginal propensity to consume (mpc) is defined as
the ratio of consumption changes to income changes
– mpc tells how much will be the change in consumption due a
change in income.
mpc = dC/dY
mps=dS/dY
mpc+mps=1
• Average propensity to consume (apc) refers to the
percentage of income that is spent on goods and services
rather than on savings.
apc= C/Y
24. Consumption Function
• Consumption function will normally be like:
• C = a+bY
Where:
C = Consumer spending
a = Autonomous consumption, or the level of
consumption that would still exist even if income was
zero,
b = Marginal propensity to consume,
Y = Real disposable income
26. Investment Function
•
•
•
•
•
•
•
In the condition of equilibrium savings are equal to investment;
implying whatever is not spent on consumption, is spent on
investment.
Gross investment is total value of productive assets created during
a given period i.e. one year.
Net investment in any given year = Gross investment minus an
estimate for replacement investment.
Private Investment: Investments made by individuals and
corporate
Public Investment: made by Government
Autonomous Investment is income inelastic. Some amount of
investment which is normally done by the Government.
Induced Investment takes place due to various factors such as
higher expected rate of return, increase in demand for capital
goods, etc.
27. Investment Function
•
•
•
•
•
In Keynesian theory inducement to invest depends upon two
factors: (i) marginal efficiency of capital and (ii) the rate of
interest.
Marginal efficiency of capital (mec) represents the demand
function of the capital goods (new investments).
Keynes defines marginal efficiency of capital as “being equal to
that rate of discount which would make the present value of
series of annuities given by the returns expected from the
capital asset during its life just equal to its supply price”.
Cost of capital is the supply price.
Marginal efficiency of capital of an asset depends upon the
prospective yield and supply price of that asset.
