Circular Flow of Income

Macroeconomic model that describes the flow of resources, goods and services, income, and expenditure between parts of the economy.

• Firms
• Households
• Government Sector
• Financial Sector
• Overseas Sector

Product Market: Exchange of products

• Firms provide output
• Households pay for the output

Factor Market: Exchange of labour, capital, land

• Households provide resources
• Firms provide income to those who provide resources

When looking at the two factor market, we must assume that:

• Households own all the resources and are buyers
• Firms are employers and produce goods and services
• Factor Market
• Product Market
• These 2 markets are interdependent

Injections: Inflow of money into the circular flow of income

• Investment (I)
• Government Expenditure (G)
• Exports (X)

Leakages: Outflow of money from the circular flow of income

• Savings (S)
• Taxation (T)
• Imports (M)

Equilibrium: When an economy is in equilibrium when sum of all leakages = sum of all injections

• When S+T+M = I+G+X
• All the income from households equals the expenditure on goods and services which equals the total production of the economy

When S>I: Flow of Y must contract

• Total spending is less than output
• Inventories increases due to less expenditure
• Firms decrease production
• Households receives less income due to decreased demand of goods and services
• Expenditure on goods and services will decrease and savings will decrease
• Repeated steps until S=I at a much lower level of total Y

Aggregate Expenditure

Measuring Economic Performance: GDP:

• Expenditure Approach: Addition of all final expenditures within a country guven a period of time
• National Income Approach: Addition of all income earned from factors of production that produce foods and services given a period of time
• Output Approach: Addition of all value of goods and services produced in a country given a period of time

Aggregate Expenditure:

• Total amount that firms, households and government plan to spend on final goods and serviecs at each level of income
• AE = C + I + G + (X - M)

Consumption Expenditure:

• Households expenditure on durable goods, non-durable goods and services
  • Durables: >3 years
  • Non-durables <3 years
  • Services: Non-commodity items
  • Autonomous vs discretionary
    • Autonomous: Necessities
    • Discretionary: Luxury Items
  • Approximately 58% of AE

Factors Affecting Consumption Expenditure

• Disposable Income
  • Increase in disposable income -> increase in consumption expenditure
• Interest Rates
  • Increase -> Save more -> Consume less
• Availability of Credit
  • Access to loans -> More incentive to take loans out and spend
• Stock of Personal Wealth
  • Wealthier -> More consumption
• Expectations
  • Expectations of Whole Economy
    • Expect economy downturn, going into a recession -> Spend less
• Government Policies
  • Fiscal Policies
    • People get more money -> More consumption
    • Increase taxes -> Decrease consumption
  • Monetary Policies
    • Decrease Spending Power / Increase -> Cash Rate (RBA) -> Interest Rates

Components of Aggregate Expenditure - Investment

• Expenditure on producer or capital goods that are used to produce final goods and services in the future
• Investment by private firms
  • Fixed Investment (usually on capital goods)
  • Residential fixed investment (private expenditure on new housing)
  • Changes in business inventories (stocks of goods that have been produced but not yet sold)
• Approximately 20% but it is very volatile

Factors Affecting Investment

• Rate of Interest
  • Real Rates - > Accounts for Inflation
  • Nominal Rates -> Doesn’t account for inflation
• Business Expectations
  • Expectation of whole economy
• Level of past profits (Profitability)
  • Had lots of past profits -> Ability to invest with that extra money
• Government Policies
  • Monetary Polices
    • Interest Rates

Components of Aggregate Expenditure - Government Expenditure

• All federal, state, local government expenditure
• 2 parts
  • G1: Current government expenditure on day to day functions
  • G2: Government expenditure used for future needs e.g schools and roads
• Approximately 24% of Aggregate Expenditure

Factors Affecting Government Expenditure

• Government Policy Objectives
  • Health Policies, Education Policies
• Current Economic Climate
  • High Inflation -> Decrease government expenditure

Components of Aggregate Expenditure - Net Exports

• Value of exports minus value of imports
  • Exports - Imports
• 0.03% of Aggregate Expenditure, volatile

Factors Affecting Net Exports

• Exchange Rates
  • Increase in AUD (Appreciation of the Australian Dollar)
    • Imports cheaper -> Increase imports
    • Exports are more expensive -> Less competitive
    • Net Exports Decrease.
• Domestic and Overseas Economic Activity
  • Australia’s Economy is good
    • Imports Increase (Capital)
  • Overseas Economy is good
    • Exports Increase
• Tariffs and Quotas
  • Tariffs -> Taxes on Imports
  • Quotas -> Limitations on trade