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The open economy circular flow model The markets National account aggregates and conversions The multiplier: – Definition of multiplier effect – Explanation.

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Presentation on theme: "The open economy circular flow model The markets National account aggregates and conversions The multiplier: – Definition of multiplier effect – Explanation."— Presentation transcript:

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2 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

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4 Households: owners of the factors of production. Households offer FOP to firmsFirms 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. 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

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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).

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

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

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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 TS = C + I + G = = TS = TP = TI Y = – 50 = Yd = Y – T = – 50 = – 900 = 250 S = Yd – C = – 900 = 250 Total leakages S + T = = 300 Equilibrium since S + T = I + G Total injections I + G = = 300

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

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21 accounting records of a country’s total production, income and expenditure. 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… 1.production method – gross domestic product GDP(P) or GDP 2.income method – gross domestic income GDP(I) or GDI 3.expenditure method – gross domestic expenditure GDP(E) or GDE

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

23 R A farmer produces 1000 bags of wheat which he sells to a miller at R10 per bag, yielding a total of R R The miller processes the wheat into flour, which he then sells to a baker for R R After baking bread with the flour, the baker sells it to a shop for R R The shop subsequently sells the bread to final consumers for R

24 R61 500

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

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

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

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29 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 ADD taxes on production SUBTRACT SUBTRACT subsidies on production = BASIC PRICES

30 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 ADD taxes on product SUBTRACT SUBTRACT subsidies = MARKET PRICES

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33 Farmer to miller for R50 Miller to Baker for R100 Baker to Consumer for R150 Expenditure method R150 Expenditure method = R150 Value of final output Production Production (value added method) = R50 + R50 + R50 = R150 Income method Income method = = R50 + R50 + R50 = R150 Value added = income earned by FOP

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

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

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

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

41 AE Y When AE Y inventories fall AE = Y Y2 Y Y1

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

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

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

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


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