1. Income and Expenditure
Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 18
The Circular Flow of
Income and Expenditure

2. 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 immediately spend all of their income on consumption.

3. Measures of Production: GDP
Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a specific time period, usually a year.
Valued at Market Value
Only Final Goods and Services Count: Sales at intermediate stages of production are not counted as their value is embodied within the final-user good. Their inclusion would result in double counting.
Excludes financial transactions and income transfers since these do not reflect production.
Must be produced within the geographic boundaries of the country.
Net additions to inventory are current period output so are also included.

4. Measuring Output as Income: GDI
Gross Domestic Income: GDI is the sum of the income (including profits) received in producing final goods and services during the period.
All of the payments made to producers are paid out to wage-earners, business owners, governments, etc. Thus in total the incomes must equal to the payments, which are equal in dollar value to the total expenditures.
Payments include:
Wages and benefits paid to workers,
Proprietors’ income,
rents,
interest,
corporate profits,
Indirect business taxes
Net factor income from abroad
Capital consumption allowance.

5. Definitions: Consumption: Purchases by households for their own use.
Closed Economy: An economy with no links of trade or finance with the rest of the world.

6. Definitions:
Tax Revenue: Total value of all taxes collected by government
Net Taxes: Tax Revenue minus transfer payments
Transfer Payments: Payments by government to individuals NOT as payment for a current period product or service.
SSI, Pensions, unemployment, disability payments, etc.

7. 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

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

9. Total leakages must equal total injections T+S+Im=G+I+Ex
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

10. 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 the form of lending to foreign borrowers, or purchases of foreign assets by domestic investors

11. 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

12. 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

13. 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

14. Components of GDP Q = C + I + G + XN
The sum of all expenditures on domestic goods and services (consumption plus all injections) must equal GDP
The basic equation for GDP:
Q = C + I + G + XN
( GDP = C + I +G + XN )
We avoid double counting/ inappropriate counting by subtracting imports from total measured expenditures; so XN = Exports - Imports

15. GDP = C + I +G + XN C = Consumption (household spending)
I = Gross Private Domestic Investment
Fixed Investment (real Capital Purchases)
Inventory Investment (changes in inventory of finished products, intermediate products, or raw materials)
G = Government Purchases
excludes transfer payments
XN = Net Exports (Exports – Imports)

16. Planned Expenditure (Ep)
Planned investment (Ip) consists of two components:
fixed investment + unplanned inventory investment
Total planned expenditure is given by the following equation:
Ep = C + Ip + G + XN

17. 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
The level of net taxes
Interest rates
Consumer confidence

18. 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
Level of foreign income

19. 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

20. Injections
For equilibrium to occur, leakages must be offset by corresponding injections.
Injections include investment, government spending, and exports.

21. Leakages and Injections

22. Spending Multiplier
The spending multiplier is a measure of the change in equilibrium income (real GDP) produced by change in autonomous expenditures (Spending that is determined independent from income levels/GDP)
By how many dollars does real GDP change for every dollar change in autonomous expenditures?
MPS: marginal propensity to save
MPI: marginal propensity to import

23. Marginal Propensities
Marginal Propensity to Consume (MPC)
Marginal Propensity to Save (MPS)
Marginal Propensity to Import (MPI)
Each of these is stated in a decimal as a share of 1. (They are considered as a percentage of disposable income generally assigned to each of category of income disposition)
For Example: MPS =0.2 means that 20% of disposable income is saved in this economy.

24. Computing the Spending Multiplier
If MPS = 0.30 and MPI is 0.10, then
MPS + MPI = 0.40 = 4/10.
1/0.40 = 1/(4/10) = 10/4 = 2.5
The multiplier is 2.5.
NOTE: The spending multiplier would be larger in a closed economy because MPI would be zero.

25. Multiplier at Work

26. Gaps

27. GDP Gap
GDP gap =
potential real GDP – actual real GDP

28. Recessionary Gap Recessionary gap
How much additional spending must occur to achieve potential GDP (i.e., to create full employment)?