Presentation on theme: "Income and Expenditure"— Presentation transcript:
1 Income and Expenditure EconomicsCombined VersionEdwin G. DolanBest Value Textbooks4th editionChapter 18The Circular Flow ofIncome 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 ValueOnly 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 taxesNet factor income from abroadCapital 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 governmentNet Taxes: Tax Revenue minus transfer paymentsTransfer 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 worldLeakages: Uses of income other than consumptionNet taxes (tax revenue minus transfer payments)SavingInjections: Expenditures on GDP other than consumptionGovernment purchases of goods and servicesInvestment
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 marketsIf 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 EconomyAn open economy is one with links to the rest of the worldOne link is a new leakage, in the form of payments made by domestic residents for imports from the rest of the worldA second link is a new injection, payments made by foreign residents for exports from the domestic economyTotal leakages must equal total injections T+S+Im=G+I+Ex
10 Financial OutflowsIf exports exceed imports, the excess earnings from sales of exports will result in financial outflows to the rest of the worldThese can take the form of lending to foreign borrowers, or purchases of foreign assets by domestic investors
11 Financial inflowsIf imports exceed exports, the excess imports must be financed by financial inflows from the rest of the worldBorrowing from foreign banks or other sourcesPurchases of domestic assets by foreign investorsThe 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)=0G-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 moderateLate 1990s: Budget surplus helped partially finance growing investment, so trade deficit remained moderateMid 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 GDPThe 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 InvestmentFixed Investment (real Capital Purchases)Inventory Investment (changes in inventory of finished products, intermediate products, or raw materials)G = Government Purchasesexcludes transfer paymentsXN = Net Exports (Exports – Imports)
16 Planned Expenditure (Ep) Planned investment (Ip) consists of two components:fixed investment + unplanned inventory investmentTotal 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 incomeThe amount of added income devoted to consumption is called the marginal propensity to consumeConsumption that takes place regardless of the level of income is called autonomous consumptionOther factors affecting consumption:Consumer wealthThe level of net taxesInterest ratesConsumer confidence
18 Determinants of other expenditures Planned investment expenditure depends onInterest ratesBusiness confidenceOther elements of the business climate in the domestic economy and abroadGovernment purchases are considered to be autonomous, that is, determined by political factors outside the economic modelNet exports depend onThe level of domestic incomeExchange ratesLevel of foreign income
19 Equilibrium in the Circular Flow The circular flow is said to be in equilibrium when total planned expenditures equal GDPIn that case, there will be no unplanned inventory investmentIf there is unplanned inventory decrease, firms respond by increasing output and the circular flow expandsIf there is unplanned inventory increase, firms respond by reducing output and the circular flow contracts
20 InjectionsFor equilibrium to occur, leakages must be offset by corresponding injections.Injections include investment, government spending, and exports.
22 Spending MultiplierThe 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 saveMPI: 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, thenMPS + MPI = 0.40 = 4/10.1/0.40 = 1/(4/10) = 10/4 = 2.5The multiplier is 2.5.NOTE: The spending multiplier would be larger in a closed economy because MPI would be zero.