S1M Circular Flow

11. The Circular Flow of Income and Expenditure( or Output and Resources)

2. The Production Possibility Frontier

Measuring Macroeconomic Activities

Mr. X spends on a final good, Parker Pen,Rs.100 which is equivalent to its market valueof Rs.100, which is equivalent to the income tofactors of production of Rs100.

So for an economy as a whole during a given year, Output Income Expenditure

because: All output produced is for transaction purpose Every transaction has a buyer and a seller. Every rupee of spending by some buyer is a

rupee of income for some seller.

HowTheEconomyWorks???

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First Model:The Circular Flow of Income and Expenditure

Economy two type of decision makers

1. Producers(Seller): who produces goods and services and sale in the market, receives income

2. Consumer ( Buyer): who spends money in exchange for goods and services bought , made expenditure

Buy and sell goods and services Output flow ( Income) Money flow ( Expenditure)So total income = total expenditure at a point of time

Francois Quesnay (1758) Tableau Economique (Economic Table) firstvisualize circular flow of income, expenditure, and output in an economy.

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The Circular Flow of Income and Expenditure

Economic Agents1. Individual/Households/Society2. Firms/Industry3. Government4. External Sector

Circular Flow of Income and Expenditure for1. One Sector 2. Two Sector3. Three Sector4. Four Sector

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The Circular Flow of Income and Expenditure: One Sector Model

Households is the only one sector

Ex, Robinson Crusoe , who lived an island Whatever it produces, it consumes So his aggregate supply AS=Y=f (N): His aggregate demand AD=C,

Equilibrium: AD= AS=>Y=C

(No exchange=> No output flow, no money flow)

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The Circular Flow of Income and Expenditure: Two Sector Model

Two Sector:1. Households:

1. Owner of all factors of productions: L,N, K, O2. Total income= R+w+i+p3. Consumes goods and services4. Made Expenditure on goods and services

2. Firms/Industry:1. They own no resources of their own2. Hire and use factors of production: L, N, K, O3. Make Factor Payments4. Produces and sell goods and services to households

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Assumptions: Producers(Firms): provide all the Goods and Services

No inventory. Make factor payment R, w, i and p.

Consumers(Household): spend all their Income on goods an services. No Savings. Owners of productive resource - land, labour, capital and enterprise

All production is sold to the consumers

No government and no overseas sectors

No inflow or outflow of income or goods and services outside or inside.

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Households income= firms expenditureHouseholds expenditure=firms Income

Flow of Money

Flow of Output

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Important Identities:Household Income (Y) Y=FPFirms Factor Payment (FP) FP= R+w+i+pIdentity: Y R+w+i+p Household Expenditure:(E) E=YFirms Supply of goods and services (Z) V=EIdentity: YV

Means Households income (Y) Factor Payments (FP) Money Value of Goods and Services (V)

SoY FP V

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(With Savings and Investment)Withdrawals and Injections:

Withdrawals: An amount that is set aside by thehouseholds and firms and is not spent ondomestically produced goods and services over a periodof timeEx. Savings is an withdrawals

Injections: An Injections is the amount that is spent byhouseholds and firms in addition to that incomegenerated within a regulated economy.Ex. Own hoarding or borrowing and spending i.e.Investment is an injection

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(With Savings and Investment)

Flow of Money

Flow of Output

All saving are made by households and entered to the firm through financial markets, So, S=I

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The Circular Flow of Income and Expenditure: Three Sector Model

Three Sector:1. Households2. Firms/Industry3. Government

1. Revenue: Direct taxes2. Expenditure: Govt. spending on goods and services3. Transfer payment: pension, unemployment benefit

If G=T balanced budgetIf G>T deficit budgetIf G

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Withdrawals Taxes are withdrawals as they reduces the

pvt disposable income of the households

Injections Govt Exp are injections as they add to

their income Transfer payment are also injections as

they add income

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The Circular Flow of Income and Expenditure: Four Sector Model

1. Households: C

2. Firms/IndustryI

3. Government Revenue: Direct taxes (T) Expenditure: Govt. spending on goods and services (G) Transfer payment (tr)

4. External SectorImport (M)Export(X)

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Assumptions: The external sector consists of only exports(X) and

imports) The export of goods and services and non-labour

services are only made by firms Households only exports labor

If X>M net gain from trade If X

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Withdrawals Imports are withdrawals as they

reduces the income of the households

Injections Exports are injections as they add to

their income

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Second Model: Production Possibilities Frontier

TheProductionPossibilitiesFrontier(PPF):agraphthatshowsthecombinationsoftwogoodstheeconomycanpossiblyproducegiventheavailableresourcesandtheavailabletechnology

q1,q2=f(A,K,L)

Example: Twogoods:computersandwheat Oneresource:labor(measuredinhours) Economyhas50,000laborhourspermonthavailableforproduction.

PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor.

5,00004,0001002,5002501,000400

50,000040,00010,00025,00025,00010,00040,000

0500050,000

EDCBA

WheatComputersWheatComputers

ProductionEmployment of labor hours

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Point on

graph

ProductionCom-puters Wheat

A 500 0B 400 1,000C 250 2,500D 100 4,000E 0 5,000 0

1,0002,0003,0004,0005,0006,000

0 100 200 300 400 500 600Computers

Wheat (tons)

AB

CD

E

PPF Example

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01,0002,0003,0004,0005,0006,000

0 100 200 300 400 500 600Computers

Wheat (tons)

AB

C

D

E

22Slope = -W/ C

Point on

graph

Production

Computers Wheat

A 500 0B 400 1,000C 250 2,500D 100 4,000E 0 5,000

PPF Example: Opportunity Cost Estimation

Toget100computerwegaveup1000wheatToget150computerwegaveup1500wheat

1computer=1000/100=10wheatOr1wheat=0.1(i.e1/10)computer

Opportunity Cost of Computer

-

101010100

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Production Possibilities Frontier

Productionpossibilitiesfrontier

b

d

a

Quantity ofComputer Produced

1,500

300

500

500 400

1,000

5,000

500

Quantity ofWheat Produced

c

a. Pareto Efficiencyb. Trade-offsb. Opportunity cost c. Impossibled. Economic growth

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A Shift in the Production Possibilities Frontier

Quantity ofComputers Produced

1500

300

1700

3500

8,000

5,000

500

Quantity ofWheat

Produced

A

G

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References: Ch 2: Macroeconomic Theory and Policy by D

N Dwivedi

Ch1 and 2 : Macroeconomics by Blanchard

Ch 2: Macroeconomics by N G Mankiw

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Thank You All

S1M Circular Flow

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