Dolan, Economics Combined Version 4e, Ch. 18 Survey of Economics Edwin G. Dolan and Kevin Klein Best Value Textbooks 4 th edition Chapter 8 The Circular Flow of Income and Expenditure

Dolan and Klein, Survey of Economics 4e, Ch. 8 The Basic Circular Flow of Income and Expenditure  This figure shows the circular flow of income and expenditure for the simplest possible economy.  Production, carried out by firms, generates incomes for households in the form of wages, interest, rents, and profits.  Households, in turn, immediately spend all of their income on consumption.

Dolan and Klein, Survey of Economics 4e, Ch. 8 Leakages and Injections in a Closed Economy  A closed economy is one that has no links to the rest of the world.  Leakages: Uses of income other than consumption  Net taxes (tax revenue minus transfer payments)  Saving  Injections: Expenditures on GDP other than consumption  Government purchases of goods and services  Investment

Dolan and Klein, Survey of Economics 4e, Ch. 8 Leakages and Injections in a Closed Economy  Total leakages must equal total injections (S+T=I+G).  If the government budget has a deficit, it must borrow from financial markets.  If the government budget has a surplus, the excess tax revenue is used to repay previous debt.

Dolan and Klein, Survey of Economics 4e, Ch. 8 An Open Economy  An open economy is one with links to the rest of the world.  One link is a new leakage, in the form of payments made by domestic residents for imports from the rest of the world.  A second link is a new injection, payments made by foreign residents for exports from the domestic economy.  Total leakages must equal total injections. T+S+Im=G+I+Ex

Dolan and Klein, Survey of Economics 4e, Ch. 8 Financial Outflows  If exports exceed imports, the excess earnings from sales of exports will result in financial outflows to the rest of the world.  These can take two forms - lending to foreign borrowers or purchases of foreign assets by domestic investors.

Dolan and Klein, Survey of Economics 4e, Ch. 8 Financial Inflows  If imports exceed exports, the excess imports must be financed by financial inflows from the rest of the world.  Borrowing from foreign banks or other sources  Purchases of domestic assets by foreign investors  The financial inflows can be used to finance a government budget deficit, for foreign investment in the private sector, or a combination of the two.

Dolan and Klein, Survey of Economics 4e, Ch. 8 The Twin Deficit Syndrome (1)  Total injections must equal total leakages: (G-T)+(I-S)+(Ex-Im)=0  G-T is the government deficit (positive if deficit)  I-S is the difference between investment and saving (positive if investment exceeds saving).  Ex-Im is the “trade deficit” (net exports) -- positive when there is a trade surplus, negative when there is a deficit. When there is a trade deficit, there must also be a financial inflow.

Dolan and Klein, Survey of Economics 4e, Ch. 8 The Twin Deficit Syndrome (2)  Early 1990s: Domestic saving sufficient to cover domestic investment plus part of the budget deficit, so trade deficit was moderate.  Late 1990s: Budget surplus helped partially finance growing investment, so trade deficit remained moderate.  Mid 2000s: Large trade deficit needed to finance growing investment and large government deficit.

Dolan and Klein, Survey of Economics 4e, Ch. 8 Components of GDP  Within the circular flow, the sum of all expenditures on domestic goods and services (consumption plus all injections) must equal GDP.  To avoid double counting of imported goods used for consumption, investment, and by government, official data must be adjusted by subtracting imports from total measured expenditures.  The basic equation for GDP: Q = C + I + G + (Ex-Im)

Dolan and Klein, Survey of Economics 4e, Ch. 8 Planned Expenditure  Planned investment (I p ) consists of two components: fixed investment + unplanned inventory investment  Total planned expenditure is given by the following equation: E p = C + I p + G + (Ex-Im)

Dolan and Klein, Survey of Economics 4e, Ch. 8 Determinants of Consumption  Consumption depends, in the first place, on disposable income.  The amount of added income devoted to consumption is called the marginal propensity to consume.  Consumption that takes place regardless of the level of income is called autonomous consumption. Other factors affecting consumption:  Consumer wealth  Level of net taxes  Interest rates  Consumer confidence

Dolan and Klein, Survey of Economics 4e, Ch. 8 Determinants of other expenditures Planned investment expenditure depends on  Interest rates  Business confidence  Other elements of the business climate in the domestic economy and abroad  Government purchases are considered to be autonomous, that is, determined by political factors outside the economic model.  Net exports depend on  The level of domestic income  Exchange rates

Dolan and Klein, Survey of Economics 4e, Ch. 8 Equilibrium in the Circular Flow  The circular flow is said to be in equilibrium when total planned expenditures equal GDP.  In that case, there will be no unplanned inventory investment.  If there is unplanned inventory decrease, firms respond by increasing output and the circular flow expands.  If there is unplanned inventory increase, firms respond by reducing output and the circular flow contracts.

Dolan, Economics Combined Version 4e, Ch. 18 Chapter 8 Appendix The Multiplier Process

Dolan, Economics Combined Version 4e, Ch. 24 Mathematics of the Multiplier  The Keynesian expenditure multiplier is equal to 1/(1-mpc) where mpc is the marginal propensity to consume.  The Keynesian expenditure multiplier measures the horizontal shift in the AD curve as a result of $1 of added government purchases.  The Keynesian net tax multiplier is equal to mpc/(1-mpc).  Note: The Keynesian expenditure multiplier is greater than the “effective multiplier” reported in many statistical studies of fiscal stimulus. The “effective multiplier” measures the amount by which the output gap is reduced by a $1 stimulus, not the amount of shift in the AD curve.