3. Macroeconomics

3. Macroeconomics - 3. Macroeconomics Circular flow of...

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3. Macroeconomics Circular flow of income The circular flow of income is one of the most useful economic models. Universities and governments use a more complicated version in order to make economic forecasts. The model is simple to start with but is made more complex by adding additional sectors to it. The first version has only two sectors, households and firms. In fig.1, firms use factors of production provided by households. Land, labour, capital and entrepreneurship are used by firms to produce a good or service. The firms pay households a reward for using these factors. Rent for land, wages for labour, interest for capital and profit for entrepreneurship. Collectively these rewards are called income and we use the letter Y to represent them. When households receive this income they use it to buy the goods and services from the firms. This we call expenditure and we use the letter E to signify it. Note that in this two sector model households spend all their income with firms. Fig.1. is a very simple model. We can add to its complexity by adding another sector, the financial sector. In fig. 2 households save some of their income and deposit it in banks and other financial institutions. Savings in economic is defined as income not spent. The banks lend money to firms who in turn invest in new machinery, factories, research and development etc. Note that investment in economics is defined as 'additions to the capital stock'. Capital you might remember is defined as 'man made goods used to produce other goods'. So in economic terminology, putting your money in a bank is not called investment it is saving. Fig 2.
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Note also that Expenditure is now made up of two items. Households spend money with firms for goods and services and this we now call consumption (C) and firms spend money with other firms (investment). Expenditure is therefore equal to consumption plus investment. E = C + I. Fig. 3 In fig. 3 we now add the government sector. Households in this model are required to pay taxes. When the government receives these taxes they then spend them (government spending) on building roads, paying soldiers, teachers and so on. In this four sector model the total amount of expenditure is equal to consumption plus investment plus government spending. E = C + I + G. Fig.4
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In fig. 4 the overseas sector is added. This model is called an open model. The previous models all assumed that the economy was closed, i.e., no foreign trade occurred. Fig. 5 Finally for this simple open model we can see that expenditure is equal to consumption plus investment plus government spending plus exports. However, because the model is now open to the outside world domestic spending on goods and services which originate outside the economy must be subtracted. Therefore imports (M) have to be subtracted. So, E = C + I + G + (X - M). The total amount of expenditure in an economy can now be renamed Aggregate Demand AD so
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This note was uploaded on 02/12/2010 for the course ECON 201 taught by Professor Smith during the Spring '10 term at Whittier.

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3. Macroeconomics - 3. Macroeconomics Circular flow of...

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