Economic Activity

Introduction The purpose of an economy is to produce goods and services for the benefit of its consumers. HOW does it do this? how WELL does it do this?

Fundamental Questions How is an economy performing? How do we measure this performance? What are we comparing this performance to? What has (or has not) contributed to this level of performance?

Overview We will be building an economic model that will allow us to look at the various parts/sectors of an economy, how they fit together, how they relate to one another, and how they contribute to the functioning of the economy.

The Two Sector Economy This is the simplest form of economy, typical of small and undeveloped societies. The Private Sector is made up of: Consumers (Households) who must earn some form of income to be able to satisfy their needs and wants. Producers (Firms) who must employ resources to be able to create the goods and services they wish to provide. coordinating the distribution of household savings to those producers who need funds. The second sector is the Financial Sector:

The Model HOUSEHOLDS FIRMS Households earn income by “selling” their productive resources to Firms Productive Resources Income

The Model Firms use these resources to create the goods and services demanded by Households. Consumption Spending Goods and Services HOUSEHOLDS FIRMS Productive Resources Income

The Model FIRMS Money flows around the inner circle, Income Consumption Spending whilst resources and commodities flow around the outside. Productive Resources Goods and Services These outside flows are called Real Flows HOUSEHOLDS

The Model FIRMS These money flows are a measure of the value of the commodities being exchanged. Productive Resources Income For example, the amount spent by Households Consumption Spending will equal the value of the goods and services produced by firms. Goods and Services So, (in this particular economy) consumer spending will indicate how much Firms have produced. HOUSEHOLDS

Income not spent by Households is saved with the Financial Sector, The Model Savings FIRMS Income Consumption Spending who then lends these funds to Firms who wish to invest in further development. Investment From now on only the MONEYFLOWS will be shown on the model. FINANCIAL SECTOR HOUSEHOLDS

The Model Again, the money flows are all anti-clockwise. The two flows across the bottom Income FINANCIAL SECTOR HOUSEHOLDS FIRMS Savings Consumption Spending Investment will always equal the Income flow across the top.

Measuring Performance How much is an economy producing? What has contributed to this?

Measuring Performance We can measure the performance of an economy by measuring the flow of money around the system, either the flow of income Income HOUSEHOLDS FIRMS or the flows of consumer spending and saving. FINANCIAL SECTOR Savings Consumption Spending Investment Either way, the two measures will come out equal. This is the value of all goods and services produced by the economy, called Gross Domestic Product So, as an equation: GDP = Y (income) and GDP = C (consumption spending) + S (savings) and GDP = C + I (investment) All of these measures will give the same answer.

As the central goal of any economy is the production of goods and services, so any measure of its performance must indicate the value of goods and services produced. represents consumer spending and therefore the value of consumer goods created in the economy. C represents spending on capital or producer goods and therefore the value of those goods created in the economy. I In a Closed Economy, therefore, C + I will represent the total production of goods and services. By examining these figures and comparing them to those of previous years you can study the contribution made by different sectors to the economy. Measuring Performance

Unplanned Investment ( a change in stocks ) Intended (or Planned) Investment However, there is more to Investment than just spending on producer goods. There are two types: I RR Both of these kinds of investment must be counted, and enable further analysis of the economy to occur. The new equation for GDP reads: C + I +  R Measuring Performance occurs when firms over-produce and have surplus stock left unsold. This unsold stock acts like Investment as it will generate revenue when it is sold at a future date. It also has an impact on the production levels of firms as they react to lower than expected sales. is the spending on plant, machinery, research and development that firms do in an effort to increase their productive capacity (and therefore their revenue) in the future.

Re-cap Income FINANCIAL SECTOR HOUSEHOLDS FIRMS Savings Consumption Spending Investment GDP = Y (income) GDP = C + I (investment) GDP = C + I +  R GDP = C + S (savings)

The Sectors in Detail What determines the level of: Consumer Spending? Planned Investment? Unplanned Investment?

The main determinant of consumer spending is level of income, but it is not as simple as that. There are in fact two types of consumer expenditure: Consumer Spending Autonomous Consumption refers to a basic level of expenditure on necessities such as food and electricity. This type of spending is constant and does not change as income rises or falls. Induced Consumption is directly related to the level of income. More income induces more spending, but Saving will also increase as income rises. The percentage of income that is spent can be expressed as a decimal and is called the marginal propensity to consume. C = a + cY So, Consumptionequals This equation is called the Consumption Function a c plus autonomous spendinga percentage of Income

Consumer Spending Here is a simple example of how the Consumption Function works. Let’s say that And in addition, consumers tend to spend 80% of their income, so the marginal propensity to consume = 0.8 Remember the consumption function is: C = a + cY $400m40m 0.8 x 400m = 320m = 360m $100m 40m 0.8 x 100m = 80m = 120m $300m 40m 0.8 x 300m = 240m = 280m $200m40m 0.8 x 200m = 160m = 200m autonomous consumption = $40m,

Consumer Spending In that previous example, spending was sometimes greater than income. The difference between income and spending is saving (called dis-saving if negative). We will continue to use the same example. Consumers use income in two ways, they either spend or save. Hence, we can get the equation: Y = C + S If Y = $400m, C will be $360m.This means that savings (S) will be $40m. If Y = $300m, C will be $280m.This means that savings (S) will be $20m. If Y = $200m, C will be $200m.This means that there will be no savings. If Y = $100m, C will be $120m.This means that savings (S) will be -$20m. As shown in the last slide...

Planned Investment As previously studied, Planned Investment (or Intended Investment) is spending by firms on plant, machinery, research and development. Unlike Consumption, Planned Investment is not primarily determined by the level of income. Businesses base their investment plans upon a number of factors: the expected return: the investment is likely to increase profits by more than the (interest) cost of the investment. prevailing interest rates: lower interest rates make a greater range of investment projects worthwhile. economic outlook: if the economy is expected to grow, profit fore- casts will be good so investment will be less risky. the size of the economy: the larger the economy, the more likely that it gain can economies of scale. This will provide funds for re-investment, especially in research and development. ALL of these factors determine the level of investment, and there is only an incidental link with Income. The level of Planned Investment is independent of Income, and therefore is FIXED in the short term.

Unplanned Investment Otherwise known as the Change on Stocks, Unplanned Investment is an important indicator that the economy responds to. We’ll further develop an earlier example to show the impact of Unplanned Investment on an economy. If:Autonomous Consumption = $40m Induced Consumption = 0.8Y and Planned Investment = $20m We will be using the following equations: C = Y Y = C + I +  R and Y = C + S For example: if Y = $500m C will be (500) = $440m So for these equations: Y = C + I +  R Y = C + S 500 =  R So  R = $40m 500 = S So S = $60m

Unplanned Investment Using these equations and figures, we can complete the table as follows: If stock levels are rising, then firms have over- estimated demand and will cut production. The result is a decrease in GDP (income will fall). If stock levels are falling, then firms have under- estimated demand and will increase production. The result is an increase in GDP (income will rise). Stock levels are still rising, so firms will continue to cut production. There will be further decreases in GDP (income will fall).

Unplanned Investment Using these equations and figures, we can complete the table as follows: Changes in Stock Levels will cause the economy to seek an equilibrium where  R = 0 You will notice that at this level of income (GDP) Savings (S) = Investment (I) so Withdrawals = Injections

Unplanned Investment And so to summarise: Income HOUSEHOLDS FIRMS Consumption Spending Savings Investment An Economy will be in EQUILIBRIUM if what’s going out...equals... what’s coming in.