Economic Issues: An introduction Outcome Two: The Circular Flow of National Income

Lesson Structure 1. Introduction 2. The ‘two sector’ model 3. A more realistic model: Injections Withdrawals 4. Changes in injections and withdrawals

5. Circular flow and Keynesian Demand Economic Policies: Problems

2. The Two Sector Model How an economy operates via a simplistic model The process of production and consumption Two basic sectors: Firms: wealth producing sector Households: consuming sector Represents how wealth is created in an economy

The ‘Two Sector’ Model Flow of resource inputs and outputs Incomes (Wages, interest, rent, profits) Factors of production (land, labour, capital and enterprise) Firms Households Output of goods and services Consumer spending Flow of resource inputs and outputs Flow of income and expenditure

There are two kinds’ relationships between firms and households: a. Monetary relationship b. Physical relationship

National Income = National Expenditure = National Output A circular flow of income is created National Income = National Expenditure = National Output (Assuming that an economy consists of only two sectors: ‘firms’ and ‘households’).

3. Injections and Withdrawals The two sector model in its present form would be realistic if: Firms paid out all the income they receive to domestic households Households used all of their income to consume the output produced by domestic firms Money would continue to flow directly between firms and households

In reality… Some income will leave the circular flow Some income will enter the circular flow Account for the government and foreign sector

Enter Injections and Withdrawals The level of national income is influenced by: Withdrawals (‘leakages’) from the circular flow of income (income entering the flow) Injections into the circular flow of income (income leaving the flow)

Injections (J) into the Circular Flow Injections into the flow will result in an increase in the level of national income Three types of injections: a. Government spending (G) b. Investment (I) c. Exports (X)

Total Injections = G + I + X Injections (J) into the Circular Flow Injections = an increase in national income Income Government Spending (G) Households Firms Investment (I) Exports (X) Consumption Total Injections = G + I + X

Withdrawals (W) from the Circular Flow Withdrawals from the flow will result in a decrease in the level of national income There are three types of withdrawals: a. Savings (S) b. Taxation (T) c. Imports (M)

Withdrawals (W) from the Circular Flow Income Taxation (T) Withdrawals represent a leakage = a decrease in national income Households Savings (S) Firms Imports (M) Consumption Withdrawals: S+T+M

The Circular Flow of Income Injections (J) Withdrawals (W) Firms Income Consumption Investment (I) Savings (S) Government Spending (G) Exports (X) Taxation (T) Imports (M) Households

4. Changes in Injections and Withdrawals How do changes in injections and withdrawals affect the level of national income in an economy? Lets examine what happens when… a. Injections are greater than withdrawals b. Injections are less than withdrawals c. Injections and withdrawals are equal

Changes in Injections and Withdrawals a. If injections are more than withdrawals: National income will rise More income entering than leaving the economy b. If injections are less than withdrawals: National income will fall More income leaving than entering the economy And Finally…

Equilibrium in the Circular Flow c. If injections are equal to withdrawals: National income remains stable The economy will be in a state of equilibrium Amount of income entering equals the amount of income leaving the economy

Class Exercise: What Happens to National Income If… 1. Individuals decide to save more of their money? National income will fall as savings represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services 2. The Government increases spending in the economy e.g. builds 10 new hospitals? National income will rise as Government expenditure represents an injection of income into the circular flow. This would increase the level of employment in the economy, in turn increasing the amount of consumer spending and income generated.

Class Exercise: What Happens to National Income If… 3. Demand for UK exports increases? National income will rise as export spending represents an injection of income into the circular flow. 4. Level of investment in the UK increases? National income will rise as increased investment represents an injection of income into the circular flow

5. The Government increases the amount of tax paid on goods and services (VAT)? National income will fall as taxation represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services 6. The demand for imports in the UK increases? National income will fall as import spending represents a withdrawal of income from the circular flow. Individuals would have less income to spend on goods and services. This income will enter the circular flow of income in another Country.

Circular Flow/Keynesian Economic Policy: Problems The level of national income in the economy will influence the level of unemployment-why? We have to consider aggregate demand (total demand for all goods and services produced in the economy) If AD in the economy falls, national income decreases If less goods and services are produced, this will lead to higher unemployment

Unemployment caused by a decrease in aggregate demand = demand deficient unemployment This type of unemployment is associated with John Maynard Keynes

Circular Flow/Keynesian Economic Policy: Problems If unemployment is caused by a lack of AD, the government should intervene in the economy to increase AD by using fiscal policy. Fiscal policy can be used to increase AD and employment by increasing government spending and/or decrease taxation Example Increasing government expenditure to create more employment and to stimulate an increase in demand for goods and services (multiplier effect). However, increasing AD to lower unemployment has various problems:

Problem One: Inflation If unemployment is caused by a lack of AD, the government should intervene in the economy to manage AD e.g. increasing government expenditure to create more employment and stimulate an increase in demand for goods and services (multiplier effect) However, as the economy nears full employment it becomes more difficult for producers to increase their output. If demand continues to rise and producers become unable to respond to these shortages, then prices will be forced upwards Inflation is one of the criticisms associated with increasing government spending to increase national output and employment

Problem Two: Budget Deficit/Crowding Out If the government increases expenditure to lower unemployment, this could lead to a budget deficit Budget deficit: government expenditure greater than revenue from taxation This increases the level of government debt in the economy The government will have to borrow money to eliminate this deficit

Problem Two: Budget Deficit/Crowding Out Increases in public borrowing can result in interest rates increasing, making the cost of borrowing more expensive for the private sector businesses. This situation can be referred to as ‘crowding-out’ the private sector. An increase in government debt and crowding out of the private sector are two additional consequences associated with increasing government spending to increase national output and employment

Problem Three: Time Lags The use of government expenditure to lower unemployment and raise national output can be subject to time lags. E.g. increase government expenditure to lower unemployment: the policy may only come into effect when the economy has already recovered and experiencing a boom Time lags is another consequence associated with increasing government spending to increase employment and national output

Problem Four: Dependence on Government Intervention Increasing government expenditure to increase levels of national output and employment was one of the main policies applied by successive governments in the 1950s and 1960s Unemployment reached historically low levels but increased government intervention through increased government expenditure was criticised by the 1970s as this policy proved to be unworkable in solving the economic difficulties experienced, particularly the economic problem of stagflation (high unemployment and high inflation) This is an additional consequence associated with increasing government spending to increase national output and employment

Output=Income=Expenditure Summary Circular Flow is a model of the economy Relationship between firms and households Output=Income=Expenditure For our model to be realistic, we have to consider: Injections into the flow Withdrawals from the flow

Three types of Injections: Government spending Exports Investment Three types of Withdrawals: Taxation Imports Savings

a. If injections are more than withdrawals: National income will rise b. If injections are less than withdrawals: National income will fall c. If injections are equal to withdrawals: National income remains stable The economy will be in a state of equilibrium