CHAPTER 1 1 THE CIRCULAR FLOW OF INCOME, NATIONAL INCOME AND MONEY Dr. Mansour Bataineh

After studying this chapter you should be able to: appreciate the difference between ex ante (plans) and ex post (outcomes) appreciate the difference between an equality and an identity understand the nature of the circular flow of income appreciate the nature of financial flows between the various sectors of the economy understand the role of money in a modern economy understand the creation of money through the loan process, and the relationship between loans and deposits. Dr. Mansour Bataineh

Interdependence The economy and society in which we live are highly complex. There are numerous economic interactions between people. You may buy goods and services from others and as you do so that provides income for those from whom you have bought the goods and services. You may sell your labour to an employer that provides your income which, in turn, enables you to buy goods and services you need from other producers, who may then employ others. Such market exchange creates interdependence between the economic agents involved: if one person does not spend, another does not receive an income. Some economies have much less market exchange and interdependence than others. These are, or were, subsistence economies where Dr. Mansour Bataineh

Interdependence families produce much of their own food and clothing with limited exchange of goods with others. However, in industrialized economies each of us produces little of what we need; we buy goods and services from a wide range of other people. What does this interdependence mean for the working of the economy as a whole? This chapter explores that question and finds that this interdependence is intimately connected to the level of national income at which the economy will settle. Dr. Mansour Bataineh

The extensive use of money Another feature of market exchange economies is the extensive use of money. Almost all transactions involve the use of money. The interdependence between people and the use of money is connected in that it is difficult to believe that an economy could be so interdependent without the use of money (or some close equivalent). When we buy and sell we use money, and the more we buy and sell the more money we use. It is usually necessary to have money in order to be able to buy things. I also consider in this chapter what the role of money is and how money is created, notably by the banking system. The banking system provides loans which are used to finance expenditure and, in the process, banks also create money. Dr. Mansour Bataineh

THE CIRCULAR FLOW OF INCOME We all know that we can have plans and intentions but that those plans cannot be carried out as we would wish for a variety of reasons. When interaction with others is involved in our plans (which is usually the case), then the plans of all those involved will in general not be mutually consistent. Hence, not all the plans can be carried through simultaneously. But when the plans are mutually consistent (say after some negotiation between those involved) they can all be realized in practice. When all the plans and intentions are fulfilled, there are no endogenous forces causing the outcome to change. Thus, it could be said that there is some form of equilibrium when the plans of economic agents are mutually consistent. Dr. Mansour Bataineh

EX ANTE vs EX POST The close relationship between mutually consistent plans and equilibrium of the system implies that it is useful to make a clear distinction between plans (or intentions) and actual outcomes. To do so I use a terminology widely used in economics: I refer to plans (intentions) as the EX ANTE position and the actual outcomes as the EX POST position. I will use the terms plans and intentions interchangeably and contrast them to the actual outcomes. Dr. Mansour Bataineh

Examples The simplest example of the difference between the two can be seen from the analysis of demand and supply that you have studied in Microeconomics. The demand curve (function) relates the amount individuals would wish (plan, intend) to buy at each price. The demand curve is the ex ante position of consumers in anyone market and indeed is something of a thought experiment, for the demand curve says for each price how much would individuals wish to buy. Notice that although the demand curve asks the question of how much would be bought for each price, most of those prices are not observed in practice. Dr. Mansour Bataineh

The circular flow of income The general idea of the circular flow of income was introduced in Chapter 8 which demonstrated the equivalence of measuring national income (GDP) in terms of output, of expenditure and of factor incomes. The figures recorded in the tables of Chapter 8 are drawn from the national income accounts and refer to actual outcomes, which, to use the language of the previous sub-section, is the ex post situation. Those figures record what actually happened in a given time period (all the figures used in Chapter 8 relate to the year 2000). Dr. Mansour Bataineh

Now we will use ex ante flow of incomes. THE CIRCULAR FLOW OF INCOME can be given a planned (ex ante) interpretation or an outcome (ex post) interpretation. Now we will use ex ante flow of incomes. Dr. Mansour Bataineh

Y=C+S=C+I The above identity says that total income of the economy (Y) is identically equal to consumption expenditures (C) and savings (S) of households. It is also by construction identically equal to the value of goods and services sold to households (C) plus the investment expenditure of firms (I). In general the identity sign is used when two entities are always equal. Dr. Mansour Bataineh

Leakages and injections Savings also imply the production of consumption goods and services will be less than total production. On the other side, firms are paying out more on the factors of production (which forms the income of households) than households plan to spend. Money would be flowing out of firms. But there is an injection into the circular flow in the form of investment expenditure by firms (Figure 11.1). Dr. Mansour Bataineh

ADDING MORE SECTORS: THE GOVERNMENT AND THE REST OF THE WORLD Dr. Mansour Bataineh

MONEY AND THE ECONOMY The commonly accepted definition of money is that it is any commodity that performs the following functions in the economy: The first is that it is a unit of account. The second function is that money is a generally accepted means of payment. A third function of money is that it serves as a store of value. Dr. Mansour Bataineh

Measures of Money M0 Notes and coins in circulation plus reserves held by banks with the central bank: sometimes called 'base money' M1 M0 plus non-interest bearing bank deposits M2 Ml plus other bank retail deposits M3 M2 plus repurchase agreements, money market fund shares and paper M4 Holdings by the private sector, other than monetary financial institutions, of sterling deposits including certificates of deposit, commercial paper, bonds, liabilities arising from repurchase agreements and sterling bank bills, notes and coins Stock of money, December 2001 (£ million) Dr. Mansour Bataineh

Banks, Loans and Money Creation Transfer money through banking system Reserve system Deposits = loans + reserves Dr. Mansour Bataineh

How can central bank affect expansion? Dr. Mansour Bataineh

The amount of base money (sometimes called high-powered money) is taken as B, and this can be either held by the public as notes and coins C, or held by the banks as their reserves R. Hence: B = C + R Dr. Mansour Bataineh

The deposits held by the public with the banks are labeled D, and if r is the RRR: R = rD Or D = R/r = (B-C)/r Dr. Mansour Bataineh

c is the proportion of money held as cash. M = C + D C = cM c is the proportion of money held as cash. Substituting the values of C and D in So, B M= ----------------- (1-(1-c)(1-r) Dr. Mansour Bataineh

----------------- is known as money multiplier (1-(1-c)(1-r) Or credit multiplier Dr. Mansour Bataineh