MAIN TOPIC: MACRO ECONOMICS – PAPER 1

TOPIC 1: CIRCULAR FLOW MODEL

SUBTOPICS:

1.1 The open economy circular flow model.

 Equation
 Markets

1.2 National Account Aggregates

 National Account conversions

1.3 The multiplier

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1.1 The open economy circular-flow model

CONCEPTS related to the circular flow:

Mind-the-Gap
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Description / Definition

 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.

Diagram

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Participants

Households
 There is a flow of money and goods and services between the household
sector and business sector.
 Households are the owners of the services of factors of production and they
place their factors of production on the market so that it can be bought.
 Households earn income in the form of wages by selling their factors of
production to business.

Business Sector / Firms / Businesses / Enterprises

 Business uses factors of production to produce goods and services on which
the household sector spends their income
 Businesses place goods and services on the product market which is bought by
households to satisfy their needs
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  Business receives an income.
State / Government
 There is a flow of money and goods and services between the household
sector and the state.
 The households provide the state with labour and receive an income
(salaries/wages).
 The state provides the household with public goods and services, e.g. parks,
hospitals.
 Households pay income taxes to the state.
 This is income for the state.

 There is a flow of money and goods and services between the business sector
and the state.
 The business sector provides the state with goods and services for which the
state pays.
 The state provides the business sector with public goods and services, e.g.
roads, electricity, harbours, etc.
 Business pay company taxes to the state.

Foreign Sector
 There is a flow of goods (imports) to the business from the foreign sector
 Businesses that import these goods, pays for it.
 This will be regarded as expenditure for the business.

 There is also a flow of goods (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 income for the business.

The role of the financial sector in the circular flow

 The financial sector consists of banks, insurance companies and pension
funds.
 The financial sector act as a link between households and firms who have
surplus money and supply others in the economy who require funds.
 The money which households and firms provide to the financial sector is known
as savings.
 Businesses can Borrow money from the financial institutions and use it to
purchase capital goods.
 This spending on capital equipment by firms is regarded as investment.

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Real flow and Money flow

 Transactions takes place on markets.

 The exchange process has two components, namely:

1 Real flow: Goods and services and factors of production.

2 Money flow: The earning of money (income) and payments that is made.

Real flow
 Consumers render production factors to producers and government via the
factor market.
 Goods and services are supplied by producers via the product market to
government and consumers.
 The government provides public goods and services to consumers and
producers.
 Producers receive goods and services (imports) form and deliver goods and
services (exports) to the foreign sector.

Money Flow
 Consumers earn an income for their production factors via factors market from
businesses.
 Business sector earn an income for goods and services via the product market
from consumers and government.
 Government receive an income from consumers and businesses.
 Businesses earn an income for exports from the foreign sector and make
payments to the foreign sector for imports.

EQUATIONS

LEAKAGES AND INJECTIONS

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

In other words:

L = S + T + M
Leakages = Savings + Taxes + Import expenditure

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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).

In other words:

J = I + G + X
Injections = Investment + Government expenditure + Export Income

Equilibrium

 The economy is in equilibrium when leakages are equal to injections.

 In other words:
L=J

S+T+M = G+I+X

Disequilibrium

 The economy is in disequilibrium when:

1 Leakages are more than Injections (L > J).

2 Injections are more than Leakages (J > L).

Restoring the equilibrium causes changes to national income.

1. National Income increase when Injections are more than Leakages.

J>L

G+I+X >S+T+M

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

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

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2. National income decrease when Injections are less than Leakages.

J < L

I+G+X < S+T+M

 The amount with which leakages exceeds the injections contribute to a decreased
demand.
 Demand for goods and services drop.
 Less goods and services are produced.
 Less income for participants.

DIAGRAM: participants, financial sector and flows

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Mathematical and graphical presentation

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

In other words:

Y=E

Y = C + G + I + (X-M) = E = C + G + I + (X-M)

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Mathematical calculation

Imports expenditure (M) R40 million

Investment (I) R180 million
Consumption spending (C) R 110 million
Exports income (X) R 25 million
Government Spending (G) R110 million

The formula to calculate total income is:

Y = C + I + G + (X - M)

Calculation of the aggregate income in the economy.

Y = C + I + G + (X-M)

Y = R110 million + R180 million + R110 million + (R25 million – R40 million)

Y = R385 million

Graphical presentation

Y=E

(Enjoy Economics)

 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 separated by scale line.
 It halves the 90° angle into two equal portions of 45 ° each.

 Aggregate expenditure (AE) = C + I + G + (X - M)

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

 The curve slope upwards and to the right.

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  At an income of Y, the AE intersects the vertical axis at E.
 If planned AE increase to E1:
o This means more money is injected into the economy than what are leak
out.
o This cause an increase of Y to Y1.

MARKETS

INTRODUCTION
The circular flow model is a simplified representation of the interaction between the
participants of the economy.
Markets coordinate economic activities and determine prices for goods and services

MAIN PART

Goods/Product/Output markets
These are markets for consumer goods and services

In economics a distinction is made between goods and services:

 Goods are defined as any tangible items such as food, clothing and cars that
satisfy some human wants or need.
 Buying and selling of goods that are produced in markets, e.g.
o Capital goods market for trading of buildings and machinery
o Consumer goods market for trading of durable consumer goods, semi-
durable consumer goods and non-durable consumer goods.
 Services are defined as non-tangible actions and includes wholesale and retail,
transport and financial markets.

Factors/Resources/Input markets
 Households sell factors of production on the markets: rent for natural resources,
wages for labour, interest for capital and profit for entrepreneurship.
 The factor market includes the labour, property and financial markets.

Financial markets
 They are not directly involved in production of goods and services, but act as a link
between households, the business sector and other participants with surplus funds
 E.g. banks, insurance companies and pension funds.

Money markets
 In the money market, short term loans and very short term funds are saved and
borrowed by consumers and business enterprises.
 Products sold in this market are bank debentures, treasury bills and government
bonds.
 The SARB is the key institution in the money market.

Capital markets
 In the capital market long term funds are borrowed and saved by consumers and
business enterprises.
 The Johannesburg Security Exchange is a key institution in the capital market.
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 Products sold in this market are mortgage bonds and shares
Foreign exchange markets
 On the foreign exchange market businesses buy/sell foreign currencies to pay for
imported goods and services.
 These transactions occur in banks and consists of an electronic money transfer
from one account to another.
 The most important foreign exchange markets are in London/New York/Tokyo
 The S.A Rand is traded freely in these markets.
 e.g. when a person buys travellers’ cheques to travel abroad.

Flows
 Flows of private and public goods and services are real flows and they are
accompanied by counter flows of expenditures and taxes on the product market
 Factor services are real flows and they are accompanied by counter flows of
income on the factor market
 Imports and exports are real flows and they are accompanied by counter flows of
expenditure and revenue on the foreign exchange market

Markets are critically important institutions in our economic system because it regulates
demand and supply, and price stability as well as general business trust is ensured.

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NATIONAL ACCOUNTS AGGREGATES

 The aim of National Accounts is to provide a systematic and comprehensive

record of national economic activities.
 National income figures are NOT 100% accurate.
 There are many shortcomings or problems when we calculate or determine
national income figures.
 Despite of all these problems and shortcomings, it still remains important economic
statistics.
 South Africa uses the SYSTEM OF NATIONAL ACCOUNTS (SNA) - as suggested
by the United Nations (UN).

COMPOSITION OF NATIONAL ACCOUNTS

 GDP is the total value of final goods and services, produced within the
boundaries/borders of a country for a specific period.

 GNP is the total value of final goods and services produced by the permanent
residents of a country for a specific period.

 Another name used for GDP is Gross Value Added.

THREE METHODS THAT IS USED TO CALCULATE GDP:

 Production method - GDP (P)

 Expenditure method - GDP (E)
 Income method - GDP (I)

1. THE PRODUCTION METHOD (VALUE ADDED APPROACH / METHOD)

 When using this method, the GDP is determined by calculating the sum of the
value added at each stage of the production process.
 This method yields GDP at basic prices.
 It is the quantity multiplied with the market or production price.
 To avoid double counting, only added values are taken.
 The value of intermediate goods and services are not included in the calculation.

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Table:

Production method (Gross Value Added method) R Billions

Primary sector 129
Secondary sector 316
Tertiary sector 908
Gross Value Added / Gross Domestic Product at basic prices 1 353
Plus: Taxes on products 174
Less: Subsidies on products 4
Gross Domestic Product at market prices 1 523
(Enjoy Economics, p 11)

2. EXPENDITURE METHOD (APPROACH)

 When using this method, the GDP measure the total value of expenditure
(spending) on final goods and services, at market prices, within the geographical
borders of the country in a specific period of time.
 The spending of the three spenders in the economy is added together.
 That is spending by households, business enterprises and the state, on consumer
goods, services and capital goods.

Table:

Expenditure method R
Billions
Final consumer spending 968
Final consumer spending by the general government 307
Gross capital formation 278
Residual item 8
Gross Domestic Expenditure 1 545
Exports of goods and services 413
Less: Imports of goods and services 435
Gross Domestic Expenditure at market prices 1 523
(Enjoy Economics, p 12)

3. INCOME METHOD (APPROACH)

 When using this method, GDP measure the total remuneration earned by the
owners of factors of production within the geographical borders of the country for
their services of their factors in the production process over a period of time (year).
 This method provides the GDP at factor cost.

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Table:

Income method R
Billions
Compensation of employees 680
Net operating surplus 454
Consumption of fixed capital 190
Gross Value Added /Gross Domestic Product at factor cost 1 324
Plus: other taxes on production 34
Less: other subsidies production 5
Gross Value Added / Gross Domestic Product at basic prices 1 353
Plus: taxes on products 174
Less: subsidies on products 4
Gross Domestic Product at market prices 1 523
(Geniet Ekonomie Bl. 12)

 Net operating surplus include the total value of goods and services less the costs.

Costs consist of:

1 Intermediate goods and services
2 The cost of compensation of workers
3 The cost of fixed capital consumption.

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 has 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.

Basic Prices
 Indirect prices and subsidies are related to production process and not individual
products.
 With the production method, taxes on production is subtracted as a cost and
subsidies on production are added as an income.
 Taxes on production are payroll taxes (SITE and PAYE), recurring taxes on land &
buildings, business licenses and other licenses.
 Subsidies on production include employment subsidies and subsidies paid to
prevent pollution.

Factor cost
 GDP at basic prices MINUS other taxes on production PLUS other subsidies on
production

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 = GDP at factor cost (factor income).
Market prices
 Conversion of values from:

 Basic prices to market prices:

GDP at basic prices PLUS Taxes on products MINUS subsidies on products =
GDP at market prices.

 Factor cost to market prices:

GDP at factor cost PLUS other taxes on production MINUS subsidies on
production = GDP at basic prices PLUS taxes on products MINUS subsidies on
products = GDP at market prices.

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 relate to the income and production happening within the borders of
the country.
National figures relate to the income or production by the citizens of the country.

Example:

R Billions
GDP at market prices 1 523
Plus: Factor income earned abroad by South Africans 29
Less: Factor income earned in South Africa by foreigners 60
GNI at market prices 1 492

Nominal figures vs Real figures

Nominal figures
 It is also known as nominal or money value.
 It is also known as national product at current price.
 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 express in prices which applied in a
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 certain base year.
THE MULTIPLIER

Definition
The multiplier shows how an increase in spending (injection) produces a more than
proportional increase in national income.

 The multiplier must always be more than 1.

 The multiplier works in opposite directions.

THE MULTIPLIER IN A TWO SECTOR MODEL

1. The multiplier 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.

Example:
Y = R100 000
S = R 40 000 = 40% 0,4
C = R 60 000 = 60% 0,6

 marginal propensity to consume (mpc) = 0,6

 marginal propensity to save (mps) = 0,4

Please note:
 mpc + mps is always = 1
 mps = 1 – mpc
 mpc = 1 - mps

FORMULAE to calculate the multiplier:

Formula 1:

__1 __
α= 1 – mpc

__1__ = 1 = 1
α= 1 – mpc 1 – 0,6 0,4 = 2,5

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Formula 2:

__1 __
α= mps

__1__ = 2,5
α= 0,4

Formula 3:

∆Y
K = ∆E

 I = R40 000 bn and it increases to R50 000 bn

 ∆ I = R10 000 bn: in other words, investment in infrastructure and development
and building of houses

 Y = R100 000 bn increases to R125 000 bn

 ∆Y = R25 000 bn

∆Y
K= ∆I

R25 000
= R10 000 = 2.5 or 2½

THE MULTIPLIER IN A GRAPH

(Enjoy Economics, p 18)

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In the graph above:

 E = Original equilibrium.
 Y = Original income.
 AE = Aggregate Demand is illustrated by C + I + G
 ∆I=∆G
 Investment spending (I) is added.
 Total spending at each level of income (Y) increase with the amount of Investment.
 Government Investment increase.
 The AE curve shifts upward to AE1
 The multiplier causes that Y increase to Y1
 Planned spending determines aggregate demand.

Explain the Multiplier effect

 The multiplier relates to how much national income changes as a result of an

injection or withdrawal, such as an investment.
 Initially there is an increase in injections into the economy (investment,
government spending or export income), which would lead to a proportionate
increase in national income.
 The extra spending would have 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.
 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.
 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.

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