Module 13 Circular Flow of Income

Production possibilities Frontier (PPF)

Describes the best possible combination of two goods to produce using all of the available resources

Shows trade-off between more of one good in terms of the other

Table-1. Alternative Production Possibilities

Possibilities	Bread (in units of 1,000 Kgs)	Guns (in units of 1,000 pcs.)
A	0	15
B	1	14
C	2	12
D	3	9
E	4	5
F	5	0

As we go from A to F, we are transferring resources from the gun industry to the bread industry.

From the data in Table-1, we can prepare the graph as shown above., and draw the curve showing the PPF.

Efficiency

Operating on the frontier implies that the economy is efficient. Any point outside the frontier is an Impossible region and hence not viable. This frontier shows the schedule of choices along which society can choose to substitute guns for bread. Points outside the frontier,( say I ) , are infeasible or unattainable. Any point inside the curve, ( say U ) indicates that some resources are unemployed or not used in the best possible way. Productive Efficiency occurs when society cannot increase the output of one good without cutting back on another good.. An efficient economy is on its PPF

Circular Flow of Income –2 sector model

Income - Individuals--people living in households--work for businesses, rent their property (or their capital) to businesses, and manage and own the businesses.

Expenditure - flows of payments from businesses to households. But households then spend their incomes--on consumption goods, in taxes paid to governments (that then spend the money on goods and services), and on assets like stock certificates and bank CDs that flow through the financial sector and are then used to buy investment and other goods.

Simple two sector model firms

In the circular flow of income only households purchase goods and services from, and sell labour and capital stock to, firms

Only firms produce final goods and services though they purchase intermediate goods and services from other firms in this process

Theory of Income Determination

Return to factors of production	=	Value of final goods & services produced (GNP)

Nation Income	=	National Output

Total output	-	Value of goods & services consumed	=	Resources available for Investment

Flow of Money

Gross National Product (GNP) The output method: the total amount of goods and service produced in one year
GNE The expenditure method: the total amount of domestic spending by consumers, firms, government and foreigners
Gross National Income (GNI or Y) The income method: the total incomes earned by the factors of production involved in the production of goods and services in one year

National Output

Closed economy

– Economy with no international trade

Demand for National output by 3 groups

1) Household

2) Business

3) Government

Gross Domestic Expenditure (GDE)	=	Value of final goods & services produced Gross National Product (GNP)

Flow of resources required to produce GNP	+	Returns earned by resource owners

Gross National Product (GNP)	=	Rewards to resource owners

Gross Nation Income (GNI or Y)	=	Gross National Product (GNP)

Aggregate Demand	=	Consumer Demand	+	Firm (Business) Demand	+	Government Demand

Gross Domestic Expenditure (GDE)	=	Consumption Expenditure (C)	+	Investment Expenditure (I)	+	Government Expenditure (G)

GNP accounts when calculated using the factor income approach requires data on payments to resource owners for the use of their resources in the production process

National Income and Expenditure Equality

Expenditure	=	Value of Output	=	Income
GDE	=	GNP	=	Y	=	C	+	I	+	G

Measured 3 ways

1) a sum of expenditures

2) a sum of output (value added)

3) sum of factor income

In theory yield the same estimate of national income, in practice they seldom do, to ensure equality item known as ‘statistical discrepancy’ or ‘residual error’ is used

Open Economy

-– Economy with international trade

Foreigners buy goods and services or exports (X)

Domestic Households, Business, Government by foreign produced goods and services imports(Z)

When domestic expenditure > Output Imports(Z) > Exports(X)

When domestic expenditure < Output Imports (Z) < Exports (X)

GNP

GDE

GNP – GDE

NNP

GNP

Depreciation

If C > NNP insufficient resources would remain to produce capital goods to replace those worn out in the production process. The capital stock would decline therefore.

If depreciation were zero NNP would equal GNP but could never exceed it.

National Income

Everything that is produced, earned or spent in a country GDP / GNP

Current and Constant Prices

Changes in GNP reflect changes in real output not changes in price level

Real versus Nominal output

	Year 1 Nominal GNP			Year 2 Nominal GNP			Year 2 Real output GNP at year 1 price
Product	Price $	Quantity	Value $	Price $	Quantity	Value $	Price $	Quantity	Value $
Guns	100	50	5000	100	25	2500	100	25	2500
Butter	1	5000	5000	2	5000	10000	1	5000	5000
	Nominal GNP		10000	Nominal GNP		12500	GNP at Year 1 price		7500

Nominal GNP	=	Current Prices
Real GNP	=	Constant Prices

Net investment would be negative if replacement investment exceeded gross investment

Example

Suppose an economy were initially in equilibrium as shown below

Suppose further a large gap exists between potential and actual output when households decide to increase C to 90% of Y instead of the current 80% and reduce S to 10% of Y instead of 20%.

When households increase their consumption expenditure firms will experience an unplanned decrease in inventories. They must have more resources to meet the demand for increased consumption expenditure plus replacing the depleted inventory stock.

The only level of Y at which the planned savings rate of 10% of Y equals the planned I of $40bn is $400bn.

The process involves the hiring of more labour and the payment of wages to the new employees who in turn will spend 90% of their income and save 10%. This in turn will further increase the demand for goods and services and force firms to hire even more people to satisfy the increased demand for goods and services. Only when Y reaches $400bn will the demand for consumption goods and services equal the supply; inventories will be at the desired level and planned savings of $40bn will equal planned I of $40bn. Note for this expansion to occur sufficient unemployment resources must exist to enable Y to double.

From the data below calculate the GNP of the country in question by the expenditure approach or the factor incomes approach or the output approach.

GNP

Expenditure

Factor

$bn

Agricultural output

Compensation of employees

150

Construction industry output

Consumption expenditure

150

Distribution trades output

Depreciation

Exports

Firms profits

Gross Domestic Investment

Government Purchases of goods and services

Imports

Interest Income

Indirect taxes

Output of Insurance, banking and financial services industries

Manufacturing output

Mining output

Net income from abroad

Public services output (defence, health, education)

Utilities output (gas, water, electricity)

Rental Income

Self Employment Income

Subsidies

-15

Transport

GNP

250