1. Circular Flow

2. CAPS requirements The open economy circular flow model The markets
National account aggregates and conversions
The multiplier:
Definition of multiplier effect
Explanation of the multiplier process aided with a circular flow and examples

3. The participants in an open circular flow model

4. Households: owners of the factors of production.
Households offer FOP to firms
Firms use FOP to produce goods and services
Households receive income(rent, wages and salaries, interest and profit.) from firms in exchange for FOP.
Households use this income to buys goods and services in the goods market.

5. Firms: use factors of production to produce good & services Firms buy FOP’s from households in exchange for income (rent, wages and salaries, interest & profit).

6. Government: national, provincial and local Gov
Government: national, provincial and local Gov. supplies goods/services to households and also taxes households and firms. Foreign sector: countries in the rest of the world. Important for imports and exports

7. The markets in an open circular flow model

8. Factor market Goods market Financial market
HOUSEHOLDS (FOP) FIRMS (income)
(land, labour, capital, ent.) (salaries and wages, interest, rent, profits)
Goods market
Firms sell goods/services to households, other firms and the foreign sector.
Financial market
Money and capital markets.
Surplus funds deposited & loans are made in the financial market.

9. Real flows – flows of physical things.
Money flows – aka nominal flows consist of the flow of money.

10. Leakages: factors that cause a decline in the flow of spending, income and production.
Savings (S), taxes (T) & imports (M).
Decreases the flow of money and the total spending in the economy.
Injections: factors that cause an increase in the flow of spending, income and production.
Investment (I), government spending (G) & exports (X).

11. A two-sector (closed)model

12. Spending, production and income flows
Spending on goods and services (TS) = what is being produced (TP) = what is paid out as income (TI) to FOP used in production.
SPENDING FLOW
Total spending undertaken by households (consumption) and firms (investment).
TS = C + I
PRODUCTION FLOW
Consists of consumer goods/services and capital goods.
INCOME FLOW
Rent, wages/salaries, interest and profits to households from firms.

13. S is a leakage I is an injection
The total spending in the model is equal to: TS = C + I = = 1 000
TS = TP = TI
Y = 1 000
S is a leakage I is an injection
Equilibrium since S = I
C = 800 Y = 1 000
S = Y – C = – 800 = 200

14. A three-sector model

15. From this three-sector circular flow we can see that…
Demand for goods/services in our economy consists of C + I + G
Flows of spending, production and income are equal.
2 leakages: savings (S) and taxation (T).
2 injections: investment spending (I) and government spending (G).
In equilibrium leakages = injections (S + T = I + G)

16. Equilibrium since S + T = I + G
Total injections
I + G = = 300
Total leakages
S + T = = 300
S = Yd – C = – 900 = 250
TS = C + I + G = = 1 200
TS = TP = TI
Y = 1200
Yd = Y – T = – 50 = 1 150

17. The four-sector model (open circular flow)

18. From this four-sector circular flow we can see that…
Demand for goods/services in our economy consists of C + I + G + (X – M)
Flows of spending, production and income are equal.
3 leakages: savings (S) and taxation (T) and imports (M).
3 injections: investment spending (I) and government spending (G) and exports (X).
In equilibrium leakages = injections
(S + T + M = I + G + X)

19. TS = C + I + G + (X – M) = 850 + 200 + 100 + (100 – 120) = 1 130
TS = TP = TI
Y = 1 130
Injections = I + G + X
= = 400
Leakages = S + T + M
= = 400
Yd = Y – T
= – 50 = 1 080
S = Yd – C
= – 850 = 230

21. National account aggregates and conversions
National accounts: accounting records of a country’s total production, income and expenditure.
Calculated by using the circular flow model.
3 methods of calculating GDP…
production method – gross domestic product GDP(P) or GDP
income method – gross domestic income GDP(I) or GDI
expenditure method – gross domestic expenditure GDP(E) or GDE

22. Production method: Gross domestic product (GDP)
Gross domestic product (GDP): total value of final goods and services produced within the country in a given period.

23. What is the total value added of these four transactions?
A farmer produces 1000 bags of wheat which he sells to a miller at R10 per bag, yielding a total of R
The miller processes the wheat into flour, which he then sells to a baker for R
After baking bread with the flour, the baker sells it to a shop for R
The shop subsequently sells the bread to final consumers for R21 000.

24. R61 500

25. Must differentiate between final and intermediate goods – avoids double counting.

26. Expenditure method: Gross domestic expenditure (GDE)
Gross domestic expenditure (GDE): total value of spending on final goods and services within the borders of a country.
GDE = C + I + G

27. Income method: Gross domestic income (GDI)
Gross domestic income (GDI): measures income earned by the FOP in the production of the GDP of a country. GDI measures income of all the people (citizens and foreigners) within the borders of a country. GNI measures income of all SA citizens even outside the borders of SA.

28. Factor Prices (cost), Basic Prices and Market Prices

29. Factor prices to basic prices
Used when GDP is calculated according to factor cost. Differs from production approach because of taxes and subsidies on production not reflected in the factor prices. Solution… ADD taxes on production SUBTRACT subsidies on production = BASIC PRICES

30. Basic prices to market prices
Used when the GDP is calculated according to the production approach. Basic price differs from market price due to tax/subsidy on the product. Tax on products cause market price > basic price. Subsidies on products cause basic price > market price. Solution… ADD taxes on product SUBTRACT subsidies = MARKET PRICES

31. Factor Prices (cost), Basic Prices and Market Prices

33. Do all methods give the same answer?
Farmer to miller for R50
Miller to Baker for R100
Baker to Consumer for R150
Expenditure method = R150
Value of final output
Production (value added method) = R50 + R50 + R50 = R150
Income method = = R50 + R50 + R50 = R150
Value added = income earned by FOP

35. Summary…

36. The multiplier
The multiplier: an initial change in spending changes the level of output and income by more than the initial change in spending.

38. The multiplier in the circular flow model
6. Final increase in total spending, production and income =
R2 962
(R R R R512)
2. Total production
increases by R1 000 → increase R1 000 in income.
The multiplier in the circular flow model
1. R1000 investment (buy capital goods from local firm)
5. Increase in C of R640 (80% × R800 ).
Further increase in production and income of R640.
4. Firms increase production by R800.
More FOP employed – household income increases by R800.
8.Multiplier = 1
1 – 0,8 = 5
3. Households save 20% (marginal propensity to save)
Spend 80% (marginal propensity to consume)

39. What is the marginal propensity to save in each scenario, and what is its effect?

40. Aggregate Expenditure Model
In equilibrium (E); C + I = Y
I.e. Amount spent by households (C) & Firms (I) = income earned by households (Y)
Aggregate Expenditure Model
Two sector economy: AE = C + I
AE = Y
Income (Y)

41. When AE < Y inventories accumulate When AE > Y inventories fall
Y Y Y1

42. Example: I increases by R5 mill MPC = 0.75 ∴multiplier = 4
Y increases by R20 mill
MPC = 0.75 ∴ multiplier = 4

43. MPC = 0.75 What is the new level of Y?
ANSWER = 120 Y

44. What is the multiplier? What is the MPS?
Multiplier = 10 MPS = 0,1
What is the multiplier? What is the MPS?

45. MPS =0.2 How much did AE go up by?
AE increased 4
MPS =0.2 How much did AE go up by?