Injections and Leakages Home work

Sept 26/2015

The injections-leakages model provides an alternative to the more common Keynesian

cross, aggregate expenditures-aggregate production model of the macroeconomy. Both
models provide essentially the same analysis and are essentially "two sides of the same
coin." The key difference between the two models is that consumption is explicitly
eliminated from the injections-leakages variation. Whereas the Keynesian cross builds on
the consumption function, the injections-leakages model builds on the saving
A Keynesian Overview
Keynesian economics is a theory of macroeconomics developed by John Maynard Keynes
based on the proposition that aggregate demand is the primary source of business-cycle
instability and the most important cause of recessions. Keynesian economics points to
discretionary government policies, especially fiscal policy, as the primary means of
stabilizing business cycles and tends to be favored by those on the liberal end of the political
spectrum.
Injections and Leakages
One half of the injections-leakages model is injections, which are non-consumption
expenditures on aggregate production. The three injections are investment expenditures,
government purchases, and exports. These are termed injections because they are
"injected" into the core circular flow of consumption, production, and income.
The other half of the injections-leakages model is leakages, which are non-consumption
uses of the income generated from production. The three leakages are saving, taxes, and
imports. These are termed leakages because they are "leaked" out of the core circular flow
of consumption, production, and income.
Equilibrium in the injections-leakages model relies on a balance between the injections into
the core circular flow and leakages out of the flow. If leakages match injections, then the
volume of the core circular flow does not change. This is the same as achieving a balance
between the water flowing form a faucet into a sink and that flowing out through the drain.
When these two flows are equal, then the total amount of water IN the sink does not
change. Equilibrium!
The Circular Flow

The Circular Flow

Injections and leakages can be best illustrated using the standard circular flow model of the
macroeconomy, such as that presented in the exhibit to the right. The circular flow is a
handy model of macroeconomic activity that highlights the interaction between households
and businesses through the product and resource markets.
The business sector is at the right and the household sector is at the left. The product
markets are at the top and the resource markets are at the bottom. The household sector
buys production from the business sector through the product markets. Expenditures by the
household sector are consumption expenditures. Revenue going to the business sector is
gross domestic product.
The business sector hires factor services from the household sector through the resource
markets. Payments made by the business sector are factor payments. Income going to the
household sector is national income.
These four parts -- consumption expenditures, gross domestic product, factor payments,
and national income -- are the core of the circular flow. They are the "engine" that drives
the macroeconomy.
Let's now consider how injections and leakages relate to this core circular flow.

Injections: The three injections -- investment, government purchases, and exports -can be displayed by clicking the [Injections] button. These injection expenditures,
like consumption, are used to purchase aggregate production through the product
markets. Most importantly, injections add to the total volume of the basic circular
flow. That is, they "inject" revenue into the product markets that is used for factor
payments and becomes household income.

Leakages: The three leakages -- saving, taxes, and imports -- can be displayed by
clicking the [Leakages"] button. These leakages, like consumption, are how the
household sector divides up or uses its income. Most importantly, leakages subtract
from the total volume of the basic circular flow. That is, they "leak" income away

from the product markets, making less available for factor payments and household
income.
The critical implication from the circular flow is that a balance between injections and
leakages maintains a constant flow of income, consumption, production, and factor
payments moving between the household and business sectors. This is the essence of
macroeconomic equilibrium -- the level of aggregate production remains unchanged.
However, if injections exceed leakages, then the volume of the basic flow expands and
aggregate production increases. Alternatively, if leakages exceed injections, then the
volume of the basic flow contracts and aggregate production decreases. As we shall see,
this change in production is what moves the economy to an equilibrium balance.
The Injections-Leakages Balance
A balance between injections and leakages generates the same equilibrium as a balance
between aggregate expenditures and aggregate production. A little manipulation of the Y =
AE equilibrium condition illustrates why.

Aggregate expenditures (AE) are the sum of consumption (C), investment (I),
government purchases (G), and net exports (X - M).
AE = C + I + G + (X - M)

The income generated by aggregate production (Y) is used by the household sector
for consumption (C), saving (S), and taxes (T).
Y=C+S+T

Substituting each of these equations into the Y = AE equilibrium condition gives us:
C + S + T = C + I + G + (X - M)

Because consumption (C) is on both sides, it cancels out.

S + T = I + G + (X - M)

For reasons that will be apparent later, let's move imports (M) to the left-hand side.

S+T+M=I+G+X
This last equation indicates that equilibrium can be achieved by equating injections I + G +
X with leakages S + T + M. Most importantly, when aggregate expenditures equal aggregate
production (Y = AE), then injections are necessarily equal to leakages S + T + M = I + G +
X.
The Injections-Leakages Model

The Graphical Model

The exhibit to the right presents the injections-leakages model. The horizontal green line,
labeled I + G + X, is the injections line and includes investment expenditures (I),
government purchases (G), and exports (X). The positively-sloped red line, labeled S + T +
M, is the leakages line and includes saving (S), taxes (T), and imports (M). The intersection
of the two lines is the equilibrium level of aggregate production, which matches the
equilibrium level of aggregate production generated by the Keynesian cross version of the
Keynesian model.
Three Variations
The injections-leakages model comes in three common variations, each based on a different
combination of the four macroeconomic sectors, and thus a different number of injections
and leakages.

Two-Sector Model: The simplest injections-leakages model includes the household

and business sectors. Also termed the saving-investment model, this variation is
often used to illustrate the basic operation of the model, including adjustment to
equilibrium and the multiplier process. The two-sector model captures the role of
induced activity through household saving and the role of autonomous expenditures
through business investment. Saving is the only leakage and investment is the only
injection.

Three-Sector Model: The second variation of the injections-leakages model adds the
government (or public) sector to the household and business sectors contained in the

two-sector model. This variation is used to analyze government stabilization policies,

especially how fiscal policy changes in government purchases and taxes can be used
to close recessionary gaps and inflationary gaps. Saving and taxes are the two
leakages. Investment and government purchases are the two injections.

Four-Sector Model: As the name suggests, all four macroeconomic sectors-household, business, government, and foreign--are included in the four-sector
Keynesian model. This model is not only used to capture the interaction between the
domestic economic and the foreign sector, but also provides the foundation for
detailed, empirically estimated models of the macroeconomy. Saving, taxes, and
imports are the three leakages. Investment, government purchases, and exports are
the three injections.

<= INJECTIONS

INJECTIONS LINE =>

The main plank of Keyness theory, which has come to bear his name, is the assertion that
aggregate demandmeasured as the sum of spending by households, businesses, and the
governmentis the most important driving force in an economy. Keynes further asserted
that free markets have no self-balancing mechanisms that lead to full employment.
Keynesian economists justify government intervention through public policies that aim to
achieve full employment and price stability.
The revolutionary idea
Keynes argued that inadequate overall demand could lead to prolonged periods of high
unemployment. An economys output of goods and services is the sum of four components:
consumption, investment, government purchases, and net exports (the difference between
what a country sells to and buys from foreign countries). Any increase in demand has to
come from one of these four components. But during a recession, strong forces often
dampen demand as spending goes down. For example, during economic downturns
uncertainty often erodes consumer confidence, causing them to reduce their spending,
especially on discretionary purchases like a house or a car. This reduction in spending by
consumers can result in less investment spending by businesses, as firms respond to
weakened demand for their products. This puts the task of increasing output on the
shoulders of the government. According to Keynesian economics, state intervention is
necessary to moderate the booms and busts in economic activity, otherwise known as the
business cycle.
There are three principal tenets in the Keynesian description of how the economy works:
Aggregate demand is influenced by many economic decisionspublic and
private.Private sector decisions can sometimes lead to adverse macroeconomic outcomes,

such as reduction in consumer spending during a recession. These market failures

sometimes call for active policies by the government, such as a fiscal stimulus package
(explained below). Therefore, Keynesian economics supports a mixed economy guided
mainly by the private sector but partly operated by the government.
Prices, and especially wages, respond slowly to changes in supply and demand,
resulting in periodic shortages and surpluses, especially of labor.
Changes in aggregate demand, whether anticipated or unanticipated, have their
greatest short-run effect on real output and employment, not on prices. Keynesians
believe that, because prices are somewhat rigid, fluctuations in any component of spending
consumption, investment, or government expenditurescause output to change. If
government spending increases, for example, and all other spending components remain
constant, then output will increase. Keynesian models of economic activity also include a
multiplier effect; that is, output changes by some multiple of the increase or decrease in
spending that caused the change. If the fiscal multiplier is greater than one, then a one
dollar increase in government spending would result in an increase in output greater than
one dollar.
Stabilizing the economy
No policy prescriptions follow from these three tenets alone. What distinguishes Keynesians
from other economists is their belief in activist policies to reduce the amplitude of the
business cycle, which they rank among the most important of all economic problems.
Rather than seeing unbalanced government budgets as wrong, Keynes advocated so-called
countercyclical fiscal policies that act against the direction of the business cycle. For
example, Keynesian economists would advocate deficit spending on labor-intensive
infrastructure projects to stimulate employment and stabilize wages during economic
downturns. They would raise taxes to cool the economy and prevent inflation when there is
abundant demand-side growth. Monetary policy could also be used to stimulate the
economyfor example, by reducing interest rates to encourage investment. The exception
occurs during a liquidity trap, when increases in the money stock fail to lower interest rates
and, therefore, do not boost output and employment.
Keynes argued that governments should solve problems in the short run rather than wait for
market forces to fix things over the long run, because, as he wrote, In the long run, we are
all dead. This does not mean that Keynesians advocate adjusting policies every few months
to keep the economy at full employment. In fact, they believe that governments cannot
know enough to fine-tune successfully.
The business cycle or economic cycle is the downward and upward movement of gross
domestic product (GDP) around its long-term growth trend.[1] These fluctuations typically
involve shifts over time between periods of relatively rapid economic growth (expansions or
booms), and periods of relative stagnation or decline (contractions or recessions).

Used in the indefinite sense, a business cycle is a period of time containing a single boom
and contraction in sequence.
Business cycles are usually measured by considering the growth rate of real gross domestic
product. Despite being termed cycles, these fluctuations in economic activity can prove
unpredictable.
A boom-and-bust cycle is one in which the expansions are rapid and the contractions are
steep and severe.
The circular flow of income or circular flow is a model of the economy in which the
major exchanges are represented as flows of money, goods and services, etc. between
economic agents. The flows of money and goods exchanges in a closed circuit and
correspond in value, but run in the opposite direction. The circular flow analysis is the basis
of national accounts and hence of macroeconomics.
The idea of the circular flow was already present in the work of Richard Cantillon.[2] Franois
Quesnay developed and visualized this concept in the so called Tableau conomique.[3]
Important developments of Quesnay's tableau were Karl Marx' reproduction schemes in the
second volume of Capital: Critique of Political Economy, and John Maynard Keynes' General
Theory of Employment, Interest and Money. Richard Stone further developed the concept
for the United Nations (UN) and the Organisation for Economic Co-operation and
Development to the system, which is now used internationally.

The circular flow of income is a concept for better understanding of the economy as a whole
and for example the National Income and Product Accounts (NIPAs). In its most basic form
it considers a simple economy consisting solely of businesses and individuals, and can be
represented in a so called "circular flow diagram." In this simple economy, individuals
provide the labor that enables businesses to produce goods and services. These activities
are represented by the green lines in the diagram.[4]

Model of the circular flow of income and expenditure

Alternatively, one can think of these transactions in terms of the monetary flows that occur.
Businesses provide individuals with income (in the form of compensation) in exchange for
their labor. That income is, in turn, spent on the goods and services businesses produce.
These activities are represented by the blue lines in the diagram above.[4]
The circular flow diagram illustrates the interdependence of the flows, or activities, that
occur in the economy, such as the production of goods and services (or the output of the
economy) and the income generated from that production. The circular flow also illustrates
the equality between the income earned from production and the value of goods and
services produced.[4]
Of course, the total economy is much more complicated than the illustration above. An
economy involves interactions between not only individuals and businesses, but also
Federal, state, and local governments and residents of the rest of the world. Also not shown
in this simple illustration of the economy are other aspects of economic activity such as
investment in capital (producedor fixedassets such as structures, equipment, research
and development, and software), flows of financial capital (such as stocks, bonds, and bank
deposits), and the contributions of these flows to the accumulation of fixed assets. [4]