Understanding the economy

as a series of continuous
flows
 The Simple Two Sector Model
• Assume the economy is made up of two sectors—
firms and households.
• Firms produce products which they sell in the
Product Market.
• Households buy products in the Product Market.
• Firms buy resources in the Resource Market.
• Households sell resources in the Resource Market.
The Simple Two Sector Model
 The Two Sector Model
With a Financial Market
• Now assume that households do not spend all of
their income, i.e., they save.
– This represents a leakage from the circular flow.
• Assume firms need capital to produce goods and
services, thus they must engage in investment
spending.
– This represents an injection into the circular flow.
• Financial intermediaries perform the function of
bringing savers and investors together.
The Two Sector Model
With a Financial Market
 The Three Sector Model
• Our two sector model is not realistic in
anything but the most primitive society.
• Let’s assume we have a government
sector.
• What do governments do?
– They tax. (A leakage)
– They spend. (An injection)
• How does the government affect our
circular flow?
The Three Sector Circular Flow
Model
 The Four Sector Model
• In the real world, no country exists in isolation.
• Nations of the world interact with one another by
buying from and selling to each other.
• We buy imports from foreign countries. (A leakage)
• We sell exports to foreign countries. (An injection)
• Add imports and exports to our circular flow.
• How does the rest of the world affect the circular
flow model?
The Four Sector Circular Flow Model
 GDP in an Open Economy with Government
Government Spending and Taxes: Government spending and taxation policies
affect equilibrium GDP in two important ways. First, government spending is
part of autonomous spending , that is, it is an exogenous element of spending
in the economy, as it directly adds demand for the economy’s current output
of goods and services. Second, in deriving disposable income, taxes must be
subtracted from NI, and government transfer payments (state pensions and
unemployment allowances) must be added. Tax revenues may be thought of
as negative transfer payments in their effect on desired aggregate spending.
Tax payments reduce disposable income relative to NI; transfers raise
disposable income relative to NI. Net taxes are total tax revenues received by
the government minus total transfer payments made by the government. A
government’s plans for taxes and spending define its fiscal policy, which has
important effects on the level of GDP in both the short and the long run.
The Budget Balance: The budget balance is the difference between total
government revenue and total government spending-or equivalently, net taxes
minus government spending. When revenues exceed spending, the
government is running a budget surplus and reverse is budget deficit and
when there is neither deficit nor surplus then is called as balanced budget.
Government Spending and Taxes: The balance of trade responds to changes in GDP, the
price level, and the exchange rate. Exports depend on spending decisions made by foreign
consumers or overseas firms that purchase domestic goods and services. Therefore,
exports are determined by influences outside of the home country. This is autonomous, or
exogenous, spending from the point of view of the determination of domestic GDP.
Imports, however, depend on the spending decisions of domestic residents. Most
categories of spending have an import content-like outsourcing of products for making
any finished goods like TV, ACs, Cars etc. Thus, imports rise when the other categories of
spending rise. Because consumption rises when the income of domestic consumers rises,
imports of foreign produced consumption goods, and of materials that go into the
production of domestically produced consumption goods also rises with domestic income.

Foreign GDP: An increase in foreign GDP, other things being equal, will lead to an increase
in the quantity of domestic-produced goods demanded by foreign countries, that is, to an
increase in our exports and vice-versa.
Relative International Prices: Any change in the prices of home produced goods relative to
those of foreign goods will cause both imports and exports to change. What circumstances
will cause relative international prices to change? a) International differences in inflation
rates, b) and changes in exchange rates.
Exchange rate changes may be brought about by changes in interest rates implemented by
the monetary authorities. The domestic currency will generally appreciate when the
domestic interest rate is raised, and vice-versa.
 Changes in Aggregate Spending
1. Fiscal Policy: what should the government do for increasing aggregate spending in
an economy? Keynesian philosophy also to be dealt with.
• Changes in government spending
• Changes in tax rates
----Tax rates and the Multiplier ( the lower is the income tax rate, the larger is the
simple multiplier as MPC will rise.
• Balanced budget changes ( changes made in spending and tax rate )– A balanced
budget increase in government spending will have a mild expansionary effect on
GDP, and a balanced budget decrease will have a mild contractionary effect.
2. Monetary Policy: It works via the effects of interest rates on aggregate spending.
Interest rate changes effects consumption. Higher interest rate encourage people to
cut their spending in order to save more and discourage borrowing in order to spend
more. Higher interest rate also discourage investment. Interest rate changes lead to a
shift in autonomous spending ( whether it be consumption, investment, or net
exports)