Economics

Draw Basic Two Sector Circular Flow Model

Households

Receive income (wages & salaries & investments), and then purchase goods and services from firms.

Firms

Hire land and capital inputs to produce goods and services, earning revenue/profits from sales. And pay wages and rent.

Assumptions of basic Two Sector Circular flow model

Assumes that only households and firms are involved in the economy, with households providing factors of production and firms providing goods and services. It also implies that all income is spent on consumption. That there is no government intervention and no overseas trade.

What is the point of Basic Two Sector Circular Flow Model

Think about economy as a continuous flow of money/G&S between people who make them and people who buy them

Leakages From Economy

Taxation (take from wages and off prices of goods), Savings (Households may not spend all their income), Imports (households and firms may spend on imports)

Factor income

Income gained by employees for labor spent on goods within the economy

Draw Circular Flow of Income

This is an open economy

Injections from outside economy

Government spending (money spent by government on Medicare, defence, welfare benefits, education), Investment (money spent by firms on capital goods), Exports (goods sold by Australian firms abroad so outside money comes in).

Which of the following defines the circular flow of income

An economic model to illustrate how money flows around the economy

Which of the following is the correct term for spending by firms on building, machinery and training?

Investment

What would happen to the Australian economy if a foreign country decided to buy more goods and services from Australia?

Injections into the economy would increase

The circular flow demonstrates that the economy is in equilibrium when?

Income = output = expenditure

Economic Event: A survey reports a rise in confidence for UK manufacturing firms

Investment is most effected and income is most likely to increase

Economic Event: The British pound rises in value by 10% against the US dollar

Exports are the most effected with income likely to decrease

Economic event: The government decides to increase the UK road building programme by 800 million Pounds for 2013-14

Government Spending is the most effected with income likely to increase

Economic Event: The prices of many consumer goods ad services stat to fall, and people start to expect further price reductions in the future.

Savings is the most effected with income likely to increase

Define circular flow of income

Shows how money moves through an economy in a constant loop from firms to households and back again.

What is meant by the terms leakage and injection? Examples

Leakage = Is the money which leaves the economy which can occur in an open market, through taxation.

Injection = Is the money which is added back into the economy in an open market an example includes government spending.

Real-life Australia Example of Exports/Injections

• Iron ore sold to China and India

• Students from Asia coming to Australia to study at University

• Japan buys our natural gas

• America buys our gold

Real-life Australia Example of Imports/Leakages

• Australia buying from South Korea or Japan

• Buying electronics from India, China or Taiwan

• Buying machinery from South Africa

• Buying lamb from New Zealand

If Injections are greater than Leakages then?

Income rises

If Leakages are greater than Injections then?

Income Falls

If Injections are equal to leakages then?

Income stays the same

Draw detailed version of Circular flow of income

Define Business in circular flow of income

They hire land, labour & capital inputs when making products for which they pay wages and rent.

Define Government in circular flow of income

Collect taxes to fund spending on public services

Define External Sector in circular flow of income

The government buys imports from other countries and overseas businesses and consumers buy our products known as exports.

Example Exam Question: Sales from firms to other countries are falling in the UK due to strong British Pound, discuss what would happen ti the circular flow and economy?

• Cause a fall in exports due to high value of currency

• Fall in exports means injections into economy will decrease

• Firms sell less products to foreign consumers

• This may force firms to cut back, causing unemployment

• Drops income for workers in households

• Falls in consumer spending may be a result of this event

Define Macro equilibrium

The value of the output produced by firms must equal the value of income paid to resource owners, in turn must equal value of spending by households to produce output.

Macro economics equation

∑O = ∑Y = ∑E

• Where O = Output, Y = Income, E = Expenditure, ∑ = Sum of

Explain Capital Market & Financial Sector

How money moves from households to businesses through financial system and what happens when unbalanced.

Explain Basic Flow in Financial Sector

• Households save a portion of the income

• Financial institutions (banks) pool these savings

• Funds are then lent to businesses to invest in capital equipment

Explain Equilibrium in Financial Sector

• Is when Savings (S) = Investment (I)

• Means every dollar saved by households is being borrowed and spent by firms on new capital

Explain Disequilibrium in Financial Sector

• Is when Savings (S) < Investment (I)

• Sometimes firms want to invest more than households save due to seeing opportunities for innovation and wanting to expand/upgrade technology

• This signals that firms are borrowing more than what is currently being saved

• It can put upward pressure on interest rates as banks compete for limited supply of savings

Factor Market: Saving is greater than investment

• Flow of income in economy contracts

• Total spending is less than output

• Unsold stocks of goods held by firms increase

• Firms cut production

• Households receive less income

• Consumption & savings fall

Factor Market: Investment is greater than savings

• Flow of economy expands

• Total spending is more than output

• Unsold stocks of goods held by firm decrease

• Firms increase production

• Households receive more income

• Consumption & savings rise

When is level of income stable?

Only when aggregate levels of savings and investment are equal will level of income be constant

Disequilibrium in other Markets

• Overseas sector if M does not equal X

• Government Sector if T does not equal G

What is Aggregate Perspective?

Sum of parts is more important than the individual sectors

What happens if (S+T+M) > (I+G+X)

Aggregate withdrawals are greater than injection so producer output and household income will fall

What happens if (S+T+M) < (I+G+X)

Aggregate injections are greater than withdrawals so household income and producer output will rise

If (S+T+M) = (I+G+X) outline what happens in the economy if Imports increase by $20bn and all other things remain the same

(S+T+M) > (I+G+X). Therefore, there is a leakage of $20bn from the circular flow. Economy in Disequilibrium.

If (S+T+M) = (I+G+X) outline what happens in the economy if taxes increase by $30bn and exports increase by $30bn.

Leakages = injections. Therefore, the economy will remain unchanged. Economy is in equilibrium.

Reasons why individuals save

• Financial Security

• Build Wealth

• Lack of confidence in the economy

Reasons why firms invest

• Increase spending on capital

• Improve capital

• Produce G&S which they expect to increase profit

How to calculate percentage of income households are saving from circular flow:

S/Y*100 or Savings divided by income times 100

What happens to the circular flow diagram if there is an increase in investment in machinery from $400 to $600 and an initial investment of $2000?

(C+I) now exceeds current levels of output and income

• This expands output of firms sector

• Increases level of income earned during next period by amount of initial investment from $2000 to $2200

How to Calculate Consumption in circular flow diagram: (Income)

• Percentage of amount spent time the income (%*Y)

How to calculate savings from circular flow diagram: (Income)

Percentage Saved times income (2nd%*Y)

After an increase in investment what happens within the economy in the circular flow of income?

• Higher levels of consumption expenditure creates extra demand for G&S

• Firms produce more output to meet demand and employ more factors of production

• Income rises

• Economy will continuer to expand after initial increase until new equilibrium is reduced

• Saving will again equal investment

Discuss this statement: Equilibrium is usually temporary

• Level of economic activity is always changing because it consists of independent individuals/groups seeking to improve their own welfare

• Therefore, the level of savings and investment will change again as firms & households respond to events in the economy

What would happen in the economy if planned savings exceed investment?

• Economy will initially be in disequilibrium

• Savings are greater than investment which is a leakage from the circular flow model

• The level of income an output in economy must contract

• Less G&S will be purchased by households, so firms will cut their output as they notice their stocks are rising

• The might cut overtime of staff or perhaps lay off some employees

• The aggregate level of income in the economy will fall in next time period

• New equilibrium will be at a lower level of income

What is aggregate expenditure?

The total planned spending in the economy

Define Consumer Spending

• Spending by households on goods and services

• Includes durable goods, non-durable goods and services

Examples of Consumer Spending

• Food

• Clothings

• Transport

• Appliances

• Entertainment

• Health

• Education Services

Determinants of Consumer spending (Rises)

• Disposable income rises

• Household wealth rises

• Interest Rates falls

• Household confidence rises

Define Business Investment

• Spending by firms on capital goods used to produce goods and services

• Investment is usually more volatile than consumption

Examples of Business Investment

• Machinery

• Equipment

• Factories

• Warehouses

• Research

• Development inventories

Determinants of Business Investment (Rise)

• Expected profitable rises

• Interest rates fall

• New technology is introduced

• Business confidence rises

Define Government Spending

• Spending by Commonwealth State and local governments on goods, services and infrastructure

• Transfer payments are not included

What is the difference between Current expenditure and Capital expenditure?

• Current Expenditure is spending on goods and services now

• Capital Expenditure is spending on infrastructure and long-lasting assets

Examples of Government Spending

• Schools

• Hospitals

• Roads

• Defence

• Public Sector Wages

Net Exports (Differences between Exports and Imports)

• Exports is spending by overseas buyers on Australian goods and services. It adds to GDP.

• Imports is spending by Australians on overseas goods and services. Imports are subtracted from GDP.

• Net Exports are positive when exports are greater than imports

Define Disposable income

• Is the income households have available to spender save after income tax, plus any transfer payments the receive

Why Disposable income affects consumer spending

• When households have more money available they can afford higher levels pf consumption

• When disposable income falls, households usually reduce spending or delay non-essential purchases

Likely effect of Disposable income on Consumer Spending

• Rising disposable income usually increases consumer spending

• Falling disposable income usually reduces consumer spending

Define Household Wealth

• The value of assets owned by households, such as housing, savings, shares and superannuation, minus debts

Why household wealth affects consumer spending

• When wealth rises households may feel more financially secure

• This can increase confidence and reduce the need for precautionary saving

Likely effect of Household wealth on Consumer Spending

• Rising wealth usually increases consumer spending

• Falling wealth can make households more cautious and reduce spending

Define Interest Rates

• Are the cost of borrowing money and the reward for saving money

Why Interest Rates affect consumer spending

• Lower interest rates make borrowing cheaper and reduce return from saving

• This can encourage households to borrow and spend, especially on durable goods

• Higher interest rates usually do the opposite

Likely effect of Interest Rates on Consumer Spending

• Falling interest rates usually increase consumer spending

• Rising interest rates usually reduce consumer spending and increase saving

Define Household Confidence and Expectations

• Confidence refers to how positive households feel about the future, including job security, income and economic conditions

Why Household confidence affects Consumer Spending

• If households expect strong employment and rising incomes, they are more willing to spend now

• If they expect unemployment, recession or financial pressure, they may delay spending and save more

Likely effect of Household confidence on Consumer Spending

• Higher confidence usually increases consumer spending

• Lower confidence usually reduces consumer spending

Consumer Spending Determinants Exam links

• Disposable income = In a paragraph response explain cause first them link it to household spending and aggregate expenditure;

• Household Wealth = This is often called the wealth effect;

• Interest Rates = Affect both the cost of credit and the incentive to share;

• Household Confidence = Confidence mainly affect discretionary spending, especially purchases that can be postponed

Define Expected Profitability and rate of return

• Firms invest when they expect the investment will generate future revenue and profit

• The expected rate of return is the expected profit from an investment as a percentage of its cost

Why expected profitability and rate of return affects Business investment

• If expected profitability rises, more investment projects become worthwhile

• If expected profitability falls, firms are more likely to postpone or cancel investment

Likely effect of Expected Profitability and rate of return on Business Investment

• Higher expected profitability usually increases business investment

• Lower expected profitability usually reduces investment

Define Interest Rates (Firms)

• For firms interest rate represent the cost of borrowing money to finance investment