The Circular Flow Of Income

When we look at how the economy works, we see a constant cycle of spending, output, income, spending, output, income. When the economy is in equilibrium, how much is earnt equals how much is spent on output, where firms need not scale up or scale down their factor inputs.

The Circular Flow and GDP

Gross Domestic Product is the total income earnt annually by all domestic factors of production*. (It is also the sum off all revenues of firms withing domestic borders, or all output produced by domestic firms).

Income circulates hands, and certain things increase and decrease that income going rounds. Certainly, the things that change how much income a person has and how much of it they spend. If you simplify a whole economy on paper, you see this.

Income Withdrawals….

Income will decrease over time due to importing, saving and taxation. If we import, a person’s income is channeled to overseas in exchange. If we save, or rather, hoard our money, than firms make less revenues and can only pay less in wages, dividends. If our money is taxed, than the government has it, doing nothing with it, it is taken out of the economy.

Two cycles….As we can see, people supply factors of production and get rewarded with wages, divedend and interest adding together to form income. Firms supply the output that has been made by the factors in exchange for the income they have given.

Income Injections

Income will increase over time due to investment, exporting and government spending. Private sector investment adds to the income of the builders, the manufacturers and the primary sector AT HOME(please note that a significant amount of capital spending is importing materials from overseas). Exporting our goods means that we are getting some overseas income we did not have before in exchange, so this also adds to our income. Government spending(which can be public sector investment, employment or transfer payments) adds to the incomes we all have to spend.

Equilibrium, aggregate demand = aggregate supply, is where investment, public spending and exporting equals savings, taxation and importing.

The Multiplier Effect

‘The butterly who flaps their wings through a series of events can eventually create a hurricane’

Very important piece of theory. If there is a sudden change in the income people have, the eventual effect on incomes can be much more. So if the government spends another £1billion on infrastructure, the eventual effect can be a £6billion gain in incomes due to it.

AD exaggerates…….

How Does it Work? Seems weird at first how a sudden jump in earnings can come out of nowhere, but give us our example again. If government spends another £1billion, than it will employ and pay private firms for inputs. This causes an extra £1 billion in income.

Those earners now go out and spend the extra income, making extra revenues for firms. Those extra revenues become extra incomes for more who go out and spend a portion of that extra, casuing more revenues etc..Feeds right through the economy. Eventually, so many people find a rise in their income so long as consumption is strong.

The higher the marginal propensity to consume, the greater the eventual income gain for everyone, although we must also take into account importing. For every stage of the cycle where extra incomes are made, the propensity defines how much becomes revenues/incomes.

Multiplier equals…… 1/(1-MPC) is the size of the multiplier. If the MPC is 0.9, the multipler is 10, and £1billion extra becomes an extra £10billion. This follows the maths sum to infinity of series equation.

This explains why the US and UK governments were so pro-government spending during the recession, due to the propping up in employment and income this would create. Also why economic cycles can be very exaggerated….

Other Measurements of National Income and Inaccuracies

GDP is all revenues earnt by firms within domestic borders, but that does not see our incomes rise if most of them are foreign owned. Adsa’s in the UK channels it’s profits straight back to shareholders of Walmart(most of which are foreign owned), for instance.

Gross National Product GNP.

What is GNP? For this reason, domestic incomes are also estimated by the revenues earnt by all domestic owned firms anywhere in the world. This is known as GNP calculation.

Issues….You instantly think that if we have a factory overseas, most of it’s revenues go to the staff there, and only the profits and rents etc come back, giving a lower value. This is partially offset by overeas firms here paying our factors of production giving a lower value for them, but of course this issue also creates problems in the calculation.

Gross Value Added GVA

What it is….The adding to the final sale price domestic factors of production have. So say we import a computer for £5, do some work, and sell it for £500. Our gains will be £450, as the other £50 is sent overseas.

Issues…This can also be difficult to add up, as so many firms add to and sell up the production line., even selling overseas and getting it back. Double counting is easy and recording all exchanges up production is hard.

Common Inaccuracies……

The above are good enough to compare how national incomes have changed over time, even in percentage terms as we do. There are other reasons why calculation may not be entirely true.

The Black Economy

Notice the word ‘declare‘(above). Many small firms and large(accounting scandals of the sharemarket boom of 1999) can hire people to alter the figures a firm earns and not declare a portion of their revenues to avoid tax. Floating share companies can juice up their figures to make themselves look more appealing for a buyout or whatever.

Of course, there is illegal trade too. A person selling ecstacy or prostitution will not declare that to the authorities. But they are gaining income from it. The illegal side is totally wiped off GDP figures. Estmated to be 10.6% GDP(HUGE) in the UK.

Barter Economy.

A person breeding animals to exchange for sugar beet is gaining something in return for production. So is a gold miner in 1800’s USA exchanging 1kg for a house. This is unaccounted for in GDP income figures, which only measure money exchanges.

When you read stats from places like Rwanda, you wonder how those people live on a GDP per head of $1000 or something. How do they eat? Well most of their trade is direct exchange of goods/services. Money is rarely used as an exchange in a subsistence village, underestimating what each of them have.

It is best to use GDP figures in monetary economies for this reason.

Estimating Inflation

So, we have a money nominal income which is already innaccurate. When we are measuring real GDP we have to account for inflation, real GDP growth being growth minus inflation. If inflation figures are inaccurate(very hard to weight all goods precisely and so many measurements of it!), than real GDP certianly will be.

Trying to Explain why Investment=Saving in Equilibrium.

If we are in an economy where there is a balanced current account and government budget, we are in equilibrium where total investment equals total savings.

Where we have a closed economy where we have no fiscal intervention, people with their incomes either consume or save. Goods produced are capital or consumer goods. Consumption=Output in consumer goods, hence Saving =spending on capital.

Keynesian Cross and ISLM explains..

In the simple cross model, investment and government spending are assumed constant. Savings and tax increases with GDP as, with a constant marginal propensity to consume aswell as tax %, higher GDP income sees higher former. If we have balanced budget, SAVING = INVESTMENT at the cross equilibrium, where the two curves cross.

Classical Alfred Marshall Thought.

The great economist Alfred Marshall made a simple theory about this. Savings is seen as future spending, and investment is what firms put aside to make for that future consumption. The added spending from future incomes and future labour/enterprise/land costs making those incomes are assumed to cancel out. This follows high savings meaning expectations for high future spending.


One Response to The Circular Flow Of Income

  1. Pingback: Thinktank « Zahablog's Economic Page

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