MACROECONOMICS PAPER I

TOPIC 3

Circular flow & quantitative elements

Participants, markets (product and factor markets), and monetary and real flows in an
open economy
2 weeks to cover content

Week 5 Week 6

Learners should cover the following:

• The participants: • Markets - product • Derive GDP and
and factor markets GNI, define them
- households / and
consumers - business • The flows of the illuminate their
enterprises - the public variables importance:
sector
- the foreign sector • Leakages and injections - definitions
- composition
- importance
- comparison

Learners must first give an description of the following words

in their notebook:

Vocabulary List
 1
Define the term “Circular flow model”

∙ 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 workings of an economy that is
open to foreign trade.
∙ It is different to a closed economy because it includes the foreign sector.

Abbreviations used

C = Consumer spending (Expenditure)

G = Government spending (expenditure)
I = Spending (expenditure) by businesses
X = Exports
Z / M = Imports

The Circular flow diagram

Closed economy consists of THREE participants:

∙ Households
∙ Businesses
∙ Government
 2
Open economic consists of FOUR participants:
∙ Households
∙ Businesses
∙ Government
∙ Foreign sector

The Parcipants in the Economy

Households
∙ There is a flow of money and goods and services between the household sector and
business sector
∙ Households are the owners of factors of production and they sell their factors of
production on the factor market to businesses.
∙ Households earn income in the form of wages, rent, interest and profit when they
selling their factors of production to business.
∙ Businesses use the factors of production to produce goods and services which they
sell to households on the goods market.

Business Sector
∙ Business buys the factors of production on the factor market.
∙ The business sector spend money when they buy factors of production form the
households to produce goods and services
∙ The household sector receives an income and they spend their income when they buy
the goods and services on the goods market.
∙ Business receives an income.

Government
∙ There is a flow of money and goods and services between the household sector and
government.
∙ The government spend money when they buy factors of production (mainly labour)
form the households on the factor market. Households receive and income. ∙ The
government provides public goods and services to the households, e.g. social grants,
hospitals, schools, etc.
∙ Households pay taxes to the government which is an income for the government. ∙
The government uses the tax income to finance its spending.

∙ There is a flow of money and goods and services between the business sector and
government.
∙ The government spend money when they buy goods and services from the business
sector on the goods market. Businesses receive and income.
∙ The government provide public goods and services to the business sector, e.g. Roads,
harbours, Electricity, etc.
∙ Businesses pay taxes to the government which is an income for the government. ∙
The government uses the tax income to finance its spending.

Foreign Sector
 Imports
∙ There is an inflow of goods (Imports) form the foreign sector to the domestic (local)
businesses, households and government.

3
∙ Businesses, households and government import goods and services from other
countries and pay for it.
∙ This is regarded as a spending by businesses, households and government. ∙
The outflow of money for Imports is regarded as a Leakage.

Exports
∙ There is also an outflow of goods and services (Exports) from the business in the
country to the foreign sector.
∙ Businesses export their goods and services to other countries and earn money for it. ∙
This will be regarded as an income for the business, households and government. ∙
The inflow of money for Exports is regarded as an Injection.

Product market and Factor market

Goods/Product market Factor market

∙ These are markets for consumer goods ∙ Factors of production are traded on
and services. these markets.
∙ Buying and selling of goods that are ∙ Natural resources, Labour, Capital, and
produced in markets. Entrepreneurship are trade on this
∙ E.g.: market.
- Durable consumer goods
- Semi durable consumer goods
- Non-Durable consumer goods
- Services

Real Flow and Money Flow

∙ Transactions takes place on markets.

∙ The exchange process has two components, namely:

1 Real flow consists of: Goods and services and Factors of production. 2 Money flow
consists of: The earning of money (income) and payments that is made.

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).

4
Money flow
∙ Producers / Businesses spend on production factors and the households receive an
income (wages, rent, interest and profit).
∙ Household spend their income (private consumption expenditure) on goods and
services and the producers receive an income.

Leakages and Injections

Leakages
∙ A leakage represent the withdrawal of money from the economic cycle (local economy) ∙
It does not give rise to a further round of income.
∙ It causes domestic purchases on goods and services to decrease.
∙ In an open economy, the leakages are taxes (T), the expenditure on imports (Z) and
savings (S).
L=S+T+M

Leakages = Savings + Taxes + Import expenditure

Savings: It is that portion of money that is not spends on goods and services. The money
leaves the circular flow and goes to financial institutions.

Taxes: Household and businesses pay taxes to the government. This money leaves the
circular flow and goes to the government. Household pay taxes on their income and
businesses pay taxes on their profits. E.g. of taxes is Income tax and Value added tax (VAT).

Imports: It is when goods are imported from other countries. Money leaves the circular flow
because money flows to foreign countries.

5
Injections
∙ Injections represents the injection of money into the economic cycle (local economy) ∙
It refers to the flow of any spending which is not derived from income (Y) ∙ Additional
money enters the economy and it increases income
∙ Domestic purchases on goods and services increase
∙ In an open economy, injections are government spending (G), the revenue earned
from exports (X) and investment spending (I).
∙
J = I + G + X Injections = Investments + Government expenditure + Export

Income

Investments: Businesses get loans from various financial institutions and then this money is
used to buy (invest) in property, machines, equipment, etc. They also use this money to buy
stock and intermediate goods.

Government Expenditure: The government spends money on goods and services to provide
economic and social services and infrastructure, e.g. building of dams, schools, hospitals, etc.

Export: Goods and services are exported to foreign countries. Money enters the circular flow
because the foreign sector pays for the goods and services they received.

Derive GDP and GNI

Definitions
Gross Domestic It is the total value of all final goods and services
Product (GDP) produced within the borders of a country within a specific
period of time, usually a year.

Gross National It is the total value of all final goods and services
Product (GNP) produced by the permanent citizens of the country within
specific period of time, usually a year.

Gross National It is the total value of all income earned by the citizens or
Income (GNI) permanent residents of a country within a specific period
of time, usually a year.
Gross Domestic The total value of spending on goods and services within
Expenditure the country, within a specific period of time, usually a year.
(GDE)

6
Composition and Calculation

The following abbreviations mean the following:

C = Consumer spending (expenditure) by households
I = Investment spending (capital formation) by businesses
G = Government spending
X = Expenditure on exports (Exports)
Z / M = Expenditure on Imports (Imports)
The calculation of Gross Domestic Product (GDP)

GDP = C + I + G + (X – M)

The calculation of Gross National Income (GNI)

GNI = GDP + primary income from the rest of the world – primary
income to the rest of the world.

Explanation:
Primary income from the rest of the world meant that the incomes earned by South
African citizens who work in other countries are added in the national account of the
country.

Primary income to the rest of the world meant that the incomes earned by foreigners
who work in South Africa are deducted for the national accounts.

The calculation of Gross Domestic Expenditure (GDE)

GDE = C + I + G + (M – X)

Comparisons
Gross Domestic Product Gross National Income

1. Measures the performance of the 1. Measure the performance of

economy. the economy.

2. Measures Production within the 2. Measures the value of income earned

boarders of a country. by citizens or permanent residents.

3. GDP measure economic growth, an 3. GNI figures reflect the standard of living
overall picture of the state of the of people.
economy.
4. GDP can be used to compare the 4. GNI can be used to compare the
production output of coutries with standard of living of countries with
each other within a specific time. each other.

5. GDP provide figures that allow countries 5. GNI provide figures that allow countries
to can compare changes in the to compare changes in the economy.
economy.