Circular flow

The open economy circular flow model

Description:
 The circular flow model of the economy is a simplification showing how the
economy works and the relationship between income, production and
spending in the economy as a whole.
 The circular flow model of an open economy shows the works of an economy
that is open to foreign trade.
 It is different to a closed economy because it includes the foreign sector.

Four sector Diagram

Participants
Household sector:
 Households are the major consumers of economic goods and services- they
use their income to buy from firms.
 Households are the primary economic participants because they are the
owners of the four factors of production.
 Households sell factors of production in the factor market to firms.
 Households receive a remuneration from the firms in the form of wages, rent,
interest, and profit.

Firms/business sector:
  Firms purchase the factors of production from the household in the factor
market.
 Firms use the factors of production to produce goods and services.
 Businesses sell goods and services to households, government and the
foreign sector.
 Businesses receive an income from the other three participants. (households,
government and the foreign sector)

The state/public sector:

 This refers to the local, regional, and national government.
 The state provides the households and businesses with public goods and
services.
 The state receives taxes from households, e.g. income tax.
 The state receives taxes from the business sector, e.g. company tax.
 The state spends money in the economy. (G)

Foreign sector
 There is a flow of goods or imports that flow from the foreign sector and are
paid for by individual households, businesses and the public sector.
 There imports can be seen as expenditure by individual households,
businesses and public sector. (a monetary flow)
 There is also a flow of goods and services to the foreign sector from
businesses.(exports)
 These exports will result in an income for individual households, businesses,
and the public sector. (A monetary inflow)

Interaction between participants:

• Households provide production factors to producers (firms).
• Households receive an income (Y) in return – rent, wages, interest and profits.
• Households purchase goods and services from firms.
• Firms receive income from sales revenue.
• Households and firms purchase goods and services from the foreign sector as
imports (M).
• The foreign businesses receive money from firms and households.
• Firms sell goods and services to the foreign sectors, and this is called exports (X).
• Households and firms pay taxes to the government. (T)
• The government provides public goods and services to households and firms.
• The unexhausted (unspent) part of the household and firms’ income earned is
saved in the financial sector of the economy. (S)
• The money invested by firms and households is known as savings (S).
• The funds received by the financial sector are used by firms/ businesses to
purchase infrastructure for the production of goods and services.
• This flow of money from the financial sector for use by firms is known as investment
(I).

Real and money flow

• Real flow: Factors of production flow from the owners (households) to producers
via the factor markets. Goods and services flow from the producers via the goods
markets to households and other users of goods and services. Factors of production
and goods and services flow from foreign countries to South Africa (imports). Factors
of production and goods and services flow from South Africa to foreign countries
(exports).
• Money flow: Factor remuneration represents the expenditure of producers and the
income of households (wages, rent, interest and profit). On the other hand,
consumption expenditure represents the expenditure of households and the income
of producers.

Leakages and injections

Leakages refer to the outflow of money from the economy.
The following are leakages or withdrawals from the circular flow:
• Savings (S)
• Taxation (T)
• Payment for Imports (M)

Injections refer to an inflow of money into the economy.

The following are injections (additions to) the circular flow:
• Investment (I)
• Government expenditure (G)
• Payments for exports (X)

Equations
Equilibrium
• The economy is in equilibrium when leakages are equal to injections.
• In other words

Disequilibrium
The economy is in disequilibrium when:
• Leakages are more than Injections.
• Injections are more than Leakages. Restoring the equilibrium causes changes to
national income

National Income increases when Injections are more than

Leakages

• The amounts of injections which exceed leakages contribute to additional demand.

• This additional demand must be satisfied.
• This causes an increase in the production of goods and services.

National Income decreases when Injections are less than

Leakages

• The amount by which leakages exceed the injections contributes to a decreased

demand.
J<L
Demand for goods and services drop.
• Less goods and services are produced.
• Less income in an economy.

Mathematical and Graph Presentation

• Income (Y) is equal to Expenditure (E)

The Formula to calculate the Aggregate Income in the

economy:
Y = C + I + G + (X – M)

• Expenditure is (E) and it is shown on the Vertical axis.

• Income is (Y) and it is shown on the Horizontal axis.
• E = Y and it is represented by a 45° line.
• It halves the 90° angle into two equal portions of 45°.

• Aggregate Expenditure (AE) = C + I + G + (X – M)

• This curve shows the amount which consumers, producers, government and the
foreign sector plan to spend at every level of income.
• It also equals aggregate demand.

• The curve slopes upwards and to the right.

• At an income of Y the AE intersects the vertical axis at E.
• Assume planned AE increases to E1.
• This means more money is injected into the economy.
• This causes an increase in Y to Y1

Markets:
Activity 1:
Study the diagram below and answer the questions that follow:

1.1 Use the information below and calculate the values A – G:

 Total production R25 000
Income Taxation R 5 000
Savings R4 000
Imports R 3 700
1.2 Explain the impact of an increase in income taxes on the level of production.
1.3 Calculate the total leakages (L) in the above diagram.

National account aggregates

Deriving national account aggregates
The national account aggregates are methods that are used to determine the value
of economic activity. The production method, income method and expenditure
method are three different ways the economic activity is measured. They are all used
at different times and for different purposes. Be sure you learn how to use these
methods

The production (output value added) method

The production method is a method whereby we determine the Gross Domestic
Product at basic prices by adding the final values of all goods and services produced
in the primary, secondary and tertiary sectors.
In the national accounts Gross Domestic Product at basic prices is usually referred
to as Gross Value Added (GVA) at basic prices.

Example:
Determine the gross domestic product at market prices according to the production
method.

The income method

The income method is a method whereby we determine the gross domestic product
– GDP at factor prices (factor cost) by adding all the income earned by the owners of
the factors of production (gross domestic income).
In the national accounts this is referred to as Gross Value Added at factor cost.

The expenditure method

The expenditure method is a method whereby we determine the gross domestic
product – GDP – at market prices by adding the spending of the four main sectors of
the economy – households (C), government (G), businesses (I) and foreign sector (X
– M).
Differentiate between GDE and Expenditure on GDP: GDE = C + I + G
Expenditure on GDP = C + I + G + (X – M)

National Account Conversions

• All countries use national account figures
• South Africa uses the SYSTEM OF NATIONAL ACCOUNTS (SNA) prescribed by
the United Nations.
• GDP, GDE, and GDI have a great deal to do with the prices we use such as
nominal and real prices, prices before or after taxes.
• Indirect taxes and subsidies are the most important determinants of the end values
of the circular flow aggregates.
Factor Cost
• Factor cost is used with the income method of measuring economic activity.
• GDP at factor cost – other taxes on production – other subsidies on production =
GDP at basic prices.
Basic Prices
• Used with the production method.
• Includes taxes on production and excludes subsidies on production.
• Taxes on production are payroll taxes (SITE and PAYE), recurring taxes on land &
buildings, business licenses.
• Subsidies on production include employment subsidies and subsidies paid to
prevent pollution.
Market prices
• Used with the expenditure method.
• Conversion of values from:
– Basic prices to market prices: GDP at basic prices + taxes on products –
subsidies on products = GDP at market prices.
– Factor cost to market prices: GDP at factor cost + other taxes on production –
subsidies on production = GDP at basic prices + taxes on products – subsidies on
products = GDP at market prices.
• Taxes on products are payable per unit, e.g. VAT.
• Subsidies on products include direct subsidies paid per unit.
Net figures
Net operating surplus = surplus after taxes
Net income = income after taxes
Net fixed capital formation = After consumption of fixed capital (depreciation)
Net exports = exports – imports
Conversion of Domestic to National figures
Domestic figures (GDP) relate to the income and production happening within the
borders of the country. National figures (GNP) relate to the income or production by
the citizens of the country.
Nominal figures vs Real figures
Nominal figures
• It is also known as market or money value.
• It is also known as national product at current prices.
• Nominal value of production is calculated by multiplying the volume of the final
goods and services by their prices.
• Inflation has not yet been taken into consideration.

Real figures
• It is also known as national product at constant prices.
• The rate of inflation as expressed by the consumer price index (CPI) has been
taken into account.
• Real values of production are the nominal values of national product adjusted for
price increase.
• Real national product is the national product expressed in prices which applied in a
certain base year.

The Multiplier
• The multiplier effect is the process whereby an initial change in spending changes
the level of output and income by more than the initial change in spending.
• The formulae to calculate the value of the multiplier (M) is:
The multiplier in a two-sector model
The multiplier is derived from the marginal propensity to consume (mpc)
• The size of the multiplier depends on the proportion of any increase in income that
is spent.
• The larger the mpc the bigger the multiplier and the smaller the mpc the smaller the
multiplier.
• It is the money that stays in the economy.
E.g.
Y = R100 000
S = R40 000 = 40% 0.4
E = R60 000 = 60% 0.6
• Marginal Propensity to consume = 0.6 (mpc)
• Marginal propensity to save = 0.4 (mps)
The total of the mpc + mps is always = 1 (one)
FORMULA to calculate the Multiplier:

The multiplier in a four sector circular flow model

• The following leakages are found
– mps = marginal propensity to save
– mrt = marginal rate of taxation
– mpm = marginal propensity to import
EXAMPLE:

Explain the multiplier effect

• The multiplier relates to how much national income changes as a result of an
injection or withdrawal.
• Assume an increase in injections into the economy (investment, government
spending or exports), which would lead to a proportionate increase in national
income.
• The extra spending would have a knock-on effect and create even more spending.
• The size of the multiplier will depend on the level of leakages.
• (E.g.) assume firms increase investment spending by R1000. This is done by
ordering capital goods from domestic firms to the value of R1000.
• Initially total spending has increased by R1000. Total production has increased by
R1000, which also leads to an increase in R1000 in income. The increase in
spending = the increase in production which = an increase in income.
• But when households earn income (R1000) leakages can occur, through income
tax, savings and spending on imports.
• If this amounts to R300, then spending on domestic goods will increase by R700.
At this stage the multiplier starts to kick in.