SamueL Edha Sap ID 80201180003 Macro Economics assignment | MPE 22

Circular Income Flow in a Two Sector Economy:

Real flows of resources, goods and services have been shown in Fig. 6.1. In
the upper loop of this figure, the resources such as land, capital and
entrepreneurial ability flow from households to business firms as indicated by
the arrow mark.

In opposite direction to this, money flows from business firms to the

households as factor payments such as wages, rent, interest and profits.

In the lower part of the figure, money flows from households to firms as
consumption expenditure made by the households on the goods and services
produced by the firms, while the flow of goods and services is in opposite
direction from business firms to households.
Thus we see that money flows from business firms to households as factor
payments and then it flows from households to firms. Thus there is, in fact, a
circular flow of money or income. This circular flow of money will continue
indefinitely week by week and year by year. This is how the economy
functions. It may, however, be pointed out that this flow of money income
will not always remain the same in volume.

In other words, the flow of money income will not always continue at a
constant level. In year of depression, the circular flow of money income will
contract, i.e., will become lesser in volume, and in years of prosperity it will
expand, i.e., will become greater in volume.

This is so because the flow of money is a measure of national income and

will, therefore, change with changes in the national income. In year of
depression, when national income is low, the volume of the flow of money
will be small and in years of prosperity when the level of national income is
quite high, the flow of money will be large.

In order to make our analysis simple and to explain the central issues
involved, we take many assumptions. In the first place, we assume that
neither the households save from their incomes, nor the firms save from their
profits. We further assume that the government does not play any part in the
national economy.

In other words, the government does not receive any money from the people
by way of taxes, nor does the government spend any money on the goods and
services produced by the firms or on the resources and services supplied by
the households. Thirdly, we assume that the economy neither imports goods
and services, nor exports anything. In other words, in our above analysis we
have not taken into account the role of foreign trade. In fact we have
explained above the flow of money that occurs in the functioning of a closed
economy with no savings and no role of government.

Circular Income Flow with Saving and Investment:

In our above analysis of the circular flow of income we have assumed that all
income which the households receive, they spend it on consumer goods and
services. A result, circular flow of money speeding and income remains
undiminished. We will now explain if households save a part of their income,
how their savings will affect money flows in the economy.

When households save, their expenditure on goods and services will decline
to that extent and as a result money flow to the business firms will contract.
With reduced money receipts, firms will hire fewer workers (or lay off some
workers) or reduce the factor payments they make to the suppliers of factors
such as workers.

This will lead to the fall in total incomes of the households. Thus, savings
reduce the flow of money expenditure to the business firms and will cause a
fall in economy’s total income. Economists therefore call savings a leakage
from the money expenditure flow.

But savings by households need not lead to reduced aggregate spending and
income if they find their way back into flow of expenditure. In free market
economies there exists a set of institutions such as banks, insurance
companies, financial houses, stock markets where households deposit their
savings. All these institutions together are called financial institutions or
financial market. We assume that all the savings of households come in the
financial market. We further assume that there are no inter-households
borrowings.

It is business firms who borrow from the financial market for investment in
capital goods such as machines, factories, tools and instruments, trucks.
Firms spend on investment in order to expand their productive capacity in
future.

Thus, through investment expenditure by borrowing the savings of the

households deposited in financial market, are again brought into the
expenditure stream and as a result total flow of spending does not decrease.
Circular money flow with saving and investment is illustrated in Fig. 6.2
where in the middle part a box representing financial market is drawn. Money
flow of savings is shown from the households towards the financial market.
Then flow of investment expenditure is shown as borrowing by business
firms from the financial market.
2. Circular Income Flow in a Three Sector Economy with Government:

we have ignored the existence of government for the sake of making our
circular flow model simple. This is quite unrealistic because government
absorbs a good part of the incomes earned by households. Government
affects the economy in a number of ways.

Here we will concentrate on its taxing, spending and borrowing roles.

Government purchases goods and services just as households and firms do.
Government expenditure takes many forms including spending on capital
goods and infrastructure (highways, power, communication), on defence
goods, and on education and public health and so on. These add to the money
flows which are shown in Fig. 6.3 where a box representing Government has
been drawn. It will be seen that government purchases of goods and services
from firms and households are shown as flow of money spending on goods
and services.
Government expenditure may be financed through taxes, out of assets or by
borrowing. The money flow from households and business firms to the
government is labelled as tax payments in Fig. 6.3 This money flow includes
all the tax payments made by households less transfer payments received
from the Government. Transfer payments are treated as negative tax
payments.

Another method of financing Government expenditure is borrowing from the

financial market. This can be represented by the money flow from the
financial market to the Government and is labelled as Government borrowing
(To avoid confusion we have not drawn this money flow from financial
market to the Government). Government borrowing increases the demand for
credit which causes rate of interest to rise.

The government borrowing through its effect on the rate of interest affects
the behaviour of firms and households. Business firms consider the interest
rate as cost of borrowing and the rise in the interest rate as a result of
borrowing by the Government lowers private investment. However,
households who view the rate of interest as return on savings feel encouraged
to save more.

It follows from above that the inclusion of the Government sector

significantly affects the overall economic situation. Total expenditure flow in
the economy is now the sum of consumption expenditure (denoted by C),
investment expenditure (I) and Government expenditure (denoted by G).
Thus

Total expenditure (E) = C + I + G …..(i)

Total income (K) received is allocated to consumption (C), savings (S) and
taxes (T). Thus

Y = C + S + T … (ii)

Since expenditure) made must be equal to the income received (Y), from
equations (i) and (ii) above we have

C + I + G = C + S + T … (iii)

Since C occurs on both sides of the equation (iii) and will therefore be
cancelled out, we have

I + G = S + T …(iv)

By rearranging we obtain

G – T = S – I … (v)

Equation (v) is very significant as it depicts what would be the consequences

if government budget is not balanced, that is, if Government expenditure (G)
is greater than the tax revenue (7), that is, G >T, the government will have a
deficit budget. To finance the deficit budget, the Government will borrow
from the financial market.

For this purpose, then private investment by business firms must be less than
the savings of the households. Thus Government borrowing reduces private
investment in the economy. In other words, Government borrowing crowds
out private investment.
3. Macro Economics

Microeconomics is the study of how individual households and firms make

decisions and how they interact with onea nother in markets.

Macroeconomics is the study of the economy as a whole. The goal of

macroeconomics is to explain the economic changes that affect many
households, firms, and markets simultaneously.

Macroeconomists address diverse questions: Why is average income high in

some countries while it is low in others?

Why do prices sometimes rise rapidly while at other times they are more
stable?

Why do production and employment expand in some years and contract in

others?

What, if anything, can the government do to promote rapid growth in

incomes, low inflation, and stable employment?

These questions are all macroeconomic in nature because they concern the
workings of the entire economy. Because the economy as a whole is just a
collection of many households and many firms interacting in many markets,
microeconomics and macroeconomics are closely linked. The basic tools of
supply and demand, for instance, are as central to macroeconomic analysis as
they are to microeconomic analysis. Yet studying the economy in its entirety
raises some new and intriguing challenges. In this and the next chapter, we
discuss some of the data that economists and policymakers use to monitor the
performance of the overall economy. These data reflect the economic
changes that macroeconomists try to explain.

GDP is the most closely watched economic statistic because it is thought to

be the best single measure of a society’s economic well-being.

4. The Great Depression & 5. The classical Vs Keynesian Theory

Introduction
Worldwide economic downturn that began in 1929 and lasted until
about 1939. It was the longest and most severe depression ever experienced
by the industrialized Western world. Although the Depression originated in
the United States, it resulted in drastic declines in output, severe
unemployment, and acute deflation in almost every country of the globe. But
its social and cultural effects were no less staggering, especially in the United
States, where the Great Depression ranks second only to the Civil War as the
gravest crisis in American history

Classical Theory

The fundamental principle of the classical theory is that the economy is self‐
regulating. (Supply creates its own demand). Classical economists maintain
that the economy is always capable of achieving the natural level of real GDP
or output, which is the level of real GDP that is obtained when the economy's
resources are fully employed. While circumstances arise from time to time
that cause the economy to fall below or to exceed the natural level of real
GDP, self‐adjustment mechanisms exist within the market system that work
to bring the economy back to the natural level of real GDP. The classical
doctrine—that the economy is always at or near the natural level of real
GDP—is based on two firmly held beliefs: Say's Law and the belief that
prices, wages, and interest rates are flexible.

Say's Law. According to Say's Law, when an economy produces a certain

level of real GDP, it also generates the income needed to purchase that level
of real GDP. In other words, the economy is always capable of demanding all
of the output that its workers and firms choose to produce. Hence, the
economy is always capable of achieving the natural level of real GDP

Laissez-faire is an economic theory from the 18th century that opposed

any government intervention in business affairs. The driving principle
behind laissez-faire, a French term that translates as "leave alone"
(literally, "let you do"), is that the less the government is involved in
the economy, the better off business will be – and by extension, society
as a whole. Laissez-faire economics are a key part of free market
capitalism.
Causes for The Great Depression

1. Stock Market Crash of 1929 - Many believe erroneously that the stock
market crash that occurred on Black Tuesday, October 29, 1929 is one and
the same with the Great Depression. In fact, it was one of the major causes
that led to the Great Depression. Two months after the original crash in
October, stockholders had lost more than $40 billion dollars. Even though the
stock market began to regain some of its losses, by the end of 1930, it just
was not enough and America truly entered what is called the Great
Depression.

2. Bank Failures - Throughout the 1930s over 9,000 banks failed. Bank
deposits were uninsured and thus as banks failed people simply lost their
savings. Surviving banks, unsure of the economic situation and concerned for
their own survival, stopped being as willing to create new loans. This
exacerbated the situation leading to less and less expenditures.

3. Reduction in Purchasing Across the Board - With the stock market crash
and the fears of further economic woes, individuals from all classes stopped
purchasing items. This then led to a reduction in the number of items
produced and thus a reduction in the workforce. As people lost their jobs,
they were unable to keep up with paying for items they had bought through
installment plans and their items were repossessed. More and more inventory
began to accumulate. The unemployment rate rose above 25% which meant,
of course, even less spending to help alleviate the economic situation.

4. American Economic Policy with Europe - As businesses began failing, the

government created the Smoot-Hawley Tariff in 1930 to help protect
American companies. This charged a high tax for imports thereby leading to
less trade between America and foreign countries along with some economic
retaliation.

5. Drought Conditions - While not a direct cause of the Great Depression, the
drought that occurred in the Mississippi Valley in 1930 was of such
proportions that many could not even pay their taxes or other debts and had
to sell their farms for no profit to themselves. The area was nicknamed "The
Dust Bowl."
Keynesian Economics
Keynesian advocates believe capitalism is a good system, but that it
sometimes needs help. When times are good, people work, earn money and
spend it on things they want. The spending stimulates the economy, and
everything runs smoothly. But when the economy goes downhill, moods
change. During tougher times, businesses start closing and firing their
employees. People don't have money to spend, and they try to save what little
they have left. When people quit spending, the economy loses its momentum
and spirals farther down.

Keynesian theory says this is exactly when government intervention makes

sense. If people aren't spending, then the government has to step in and fill
the void. However, there's just one problem: The government doesn't have its
own money. It has to take money away from the people and companies to
spend it. Higher taxes for businesses take money away that could otherwise
be spent on more investments to grow the company.

Role of Government
Classical economists do not like government spending, and they especially
detest more government debt. They would prefer a balanced budget because
they do not believe the economy benefits from higher government spending.
Keynesians are okay with government borrowing, because they are
convinced that government spending increases aggregate demand in the
economy.
Unemployment and Inflation
Keynesian enthusiasts favor government involvement and are more
concerned about people having jobs than they are about inflation. They see
the role of workers as using their abilities to contribute for the good of
society. Keynesians do not worry about the cost of goods or the purchasing
power of the currency.
Classical economists have some concerns about unemployment but are more
worried about price inflation. They see inflation as the biggest threat to a
strong long-term growth of the economy. Classicists believe the economy
will always seek a level of full employment. They think unemployment
results from government interference in the free market or the existence of a
monopoly in an industry.
Prices
Classical supporters want a market that is free to find its own levels of supply
and demand. They believe that prices should fluctuate based on the wants of
consumers. The market will adjust itself to any shortages and surpluses of
products. Keynesians believe prices should be more rigid and that
government should try to maintain price stability. They would like to see the
government influence people and corporations to keep prices within specified
ranges.
The Future
A key difference between Keynesians and classicists is how to predict and
treat the future growth of the economy. Keynesians focus on short-term
problems. They see these issues as immediate concerns that government must
deal with to assure the long-term growth of the economy. Classicists focus
more on getting long-term results by letting the free market adjust to short-
term problems. They believe short-term problems are just bumps in the road
that the free market will eventually solve for itself.
Ending of The Great Depression

The Depression was actually ended, and prosperity restored, by the sharp
reductions in spending, taxes and regulation at the end of World War II,
exactly contrary to the analysis of Keynesian so-called economists. True,
unemployment did decline at the start of World War II

World War II and The Great Depression

World War II had a profound and multifaceted impact on the American

economy. Most obviously, it lifted the nation out of the Great Depression of
the 1930s. As late as 1940, unemployment stood at 14.6 percent; by 1944 it
was down to a remarkable 1.2 percent, and the gross national product (GNP)
had more than doubled. But the wartime economic mobilization did more
than end the Depression. It greatly increased the size, power, and cost of
the federal government. It corroborated the argument of the British economist
John Maynard Keynes that deficit spending could stimulate economic
growth, with consequences not only for government fiscal policy, but also for
the agenda of New Deal liberalism. It virtually revolutionized the tax
structure by vastly increasing the number of taxpayers, making personal
income taxes a larger source of federal income than corporate taxes, and
inaugurating the withholding system. It enlarged the economic and political
power of big business, spurred the mechanization of agriculture and the
further consolidation of big agribusiness, and increased the size and influence
of organized labor. It catalyzed major breakthroughs in science and
technology, including the development of the atomic bomb. It contributed to
the resurgence of conservatism in Congress that had begun in the late 1930s.
And among its other consequences, it made the United Statesoverwhelmingly
the dominant economic power in the world.

As the United States became the "arsenal of democracy" during World War
II, economic mobilization brought a double victory for the American people
by ending the decade-long Great Depression at home, as well as playing a
pivotal role in defeating the Axis Powers abroad. President Franklin D.
Roosevelt's New Deal of the 1930s had contributed to economic
improvement after the calamitous collapse of the American economy that had
led to unemployment of at least 25 percent by 1933. It had also provided
essential assistance to the impoverished and unemployed. But the New Deal
had not ended the Depression. Indeed, after some recovery from 1933 to
1937, the sharp recession of 1937 to 1938 sent economic indexes plummeting
again, with unemployment reaching 19 percent. The economy then headed up
again, but in 1940 unemployment still stood at a Depression-level 14.6
percent.
6. The consumption function

Consumption function graph

In economics, the consumption function describes a relationship

[1][2]
between consumption and disposable income. The concept is believed to
have been introduced into macroeconomics by John Maynard Keynes in
1936, who used it to develop the notion of a government spending
multiplier. [3]

Its simplest form is the linear consumption function used frequently in simple
Keynesian models:[4]

C= a+ (b x Yd)
Where ‘a’ is the autonomous consumption that is independent of disposable
income; in other words, consumption when income is zero. The term (b x
Yd) is the induced consumption that is influenced by the economy's income
level. The parameter b is known as the marginal propensity to consume, i.e.
the increase in consumption due to an incremental increase in disposable
𝜕𝐶
income, since 𝜕𝑌𝑑 = 𝑏. Geometrically, b is the slope of the consumption
function. One of the key assumptions of Keynesian economics is that this
parameter is positive but smaller than one, b ∈ (0,1)
7. Components of Aggregate demand
The aggregate-demand curve tells us the quantity of all goods and services
demanded in the economy at any given price level. As Figure 3 illustrates, the
aggregate-demand curve is downward sloping. This means that, other things
equal, a decrease in the economy’s overall level of prices (from, say, P1 to
P2) raises the quantity of goods and services demanded (from Y1 to Y2).
Conversely, an increase in the price level reduces the quantity of goods and
services demanded.
WHY THE AGGREGATE-DEMAND CURVE SLOPES DOWNWARD
Why does a change in the price level move the quantity of goods and services
demanded in the opposite direction? To answer this question, it is useful to
recall that an economy’s GDP (which we denote as Y) is the sum of its
consumption (C), investment (I), government purchases (G), and net exports
(NX):

Y = C + I + G + NX.

Each of these four components contributes to the aggregate demand for goods
and services. For now, we assume that government spending is fixed by
policy. The other three components of spending—consumption, investment,
and net exports—depend on economic conditions and, in particular, on the
price level. Therefore, to understand the downward slope of the aggregate-
demand curve, we must examine how the price level affects the quantity of
goods and services demanded for consumption, investment, and net exports.

The Price Level and Consumption: The Wealth Effect Consider the money
that you hold in your wallet and your bank account. The nominal value of this
money is fixed: One dollar is always worth one dollar. Yet the real value of a
dollar is not fixed. If a candy bar costs 1 dollar, then a dollar is worth one
candy bar. If the price of a candy bar falls to 50 cents, then 1 dollar is worth
two candy bars. Thus, when the price level falls, the dollars you are holding
rise in value, which increases your real wealth and your ability to buy goods
and services.
This logic gives us the first reason the aggregate demand curve is downward
sloping. A decrease in the price level raises the real value of money and
makes consumers wealthier, which in turn encourages them to spend more.
The increase in consumer spending means a larger quantity of goods and
services demanded. Conversely, an increase in the price level reduces the real
value of money and makes consumers poorer, which in turn reduces
consumer spending and the quantity of goods and services demanded.

The Price Level and Investment: The Interest-Rate Effect The price level is
one determinant of the quantity of money demanded. When the price level is
lower, households need to hold less money to buy the goods and services
they want. Therefore, when the price level falls, households try to reduce
their holdings of money by lending some of it out. For instance, a household
might use its excess money to buy interest-bearing bonds. Or it might deposit
its excess money in an interest-bearing savings account, and the bank would
use these funds to make more loans. In either case, as households try to
convert some of their money into interest-bearing assets, they drive down
interest rates.
Interest rates, in turn, affect spending on goods and services. Because a lower
interest rate makes borrowing less expensive, it encourages firms to borrow
more to invest in new plants and equipment, and it encourages households to
borrow more to invest in new housing. (A lower interest rate might also
stimulate consumer spending, especially spending on large durable purchases
such as cars, which are often bought on credit.) Thus, a lower interest rate
increases the quantity of goods and services demanded.
This logic gives us a second reason the aggregate demand curve is downward
sloping. A lower price level reduces the interest rate, encourages greater spending on
investment goods, and thereby increases the quantity of goods and services demanded.
Conversely, a higher price level raises the interest rate, discourages investment spending,
and decreases the quantity of goods and services demanded.

The Price Level and Net Exports: The Exchange-Rate Effect As we have
just discussed, a lower price level in the United States lowers the U.S. interest
rate. In response to the lower interest rate, some U.S. investors will seek
higher returns by investing abroad. For instance, as the interest rate on U.S.
government bonds falls, a mutual fund might sell U.S. government bonds to
buy German government bonds. As the mutual fund tries to convert its
dollars into euros to buy the German bonds, it increases the supply of dollars
in the market for foreign-currency exchange.
The increased supply of dollars to be turned into euros causes the dollar to
depreciate relative to the euro. This leads to a change in the real exchange
rate—the relative price of domestic and foreign goods. Because each dollar
buys fewer units of foreign currencies, foreign goods become more expensive
relative to domestic goods.
The change in relative prices affects spending, both at home and abroad.
Because foreign goods are now more expensive, Americans buy less from
other countries, causing U.S. imports of goods and services to decrease. At
the same time, because U.S. goods are now cheaper, foreigners buy more
from the United States, so U.S. exports increase. Net exports equal exports
minus imports, so both of these changes cause U.S. net exports to increase.
Thus, the fall in the real exchange value of the dollar leads to an increase in
the quantity of goods and services demanded.
This logic yields a third reason the aggregate demand curve is downward
sloping. When a fall in the U.S. price level causes U.S. interest rates to fall,
the real value of the dollar declines in foreign exchange markets. This
depreciation stimulates U.S. net exports and thereby increases the quantity of
goods and services demanded. Conversely, when the U.S. price level rises
and causes U.S. interest rates to rise, the real value of the dollar increases,
and this appreciation reduces U.S. net exports and the quantity of goods and
services demanded.
Summing Up There are three distinct but related reasons a fall in the price
level increases the quantity of goods and services demanded:
1. Consumers are wealthier, which stimulates the demand for consumption
goods.
2. Interest rates fall, which stimulates the demand for investment goods.
3. The currency depreciates, which stimulates the demand for net exports.
The same three effects work in reverse: When the price level rises, decreased
wealth depresses consumer spending, higher interest rates depress investment
spending, and a currency appreciation depresses net exports.

Here is a thought experiment to hone your intuition about these effects.

Imagine that one day you wake up and notice that, for some mysterious
reason, the prices of all goods and services have fallen by half, so the dollars
you are holding are worth twice as much. In real terms, you now have twice
as much money as you had when you went to bed the night before. What
would you do with the extra money? You could spend it at your favorite
restaurant, increasing consumer spending. You could lend it out (by buying a
bond or depositing it in your bank), reducing interest rates and increasing
investment spending. Or you could invest it overseas (by buying shares in an
international mutual fund), reducing the real exchange value of the dollar and
increasing net exports. Whichever of these three responses you choose, the
fall in the price level leads to an increase in the quantity of goods and
services demanded. This is what the downward slope of the aggregate-
demand curve represents.

It is important to keep in mind that the aggregate-demand curve (like all

demand curves) is drawn holding “other things equal.” In particular, our
three explanations of the downward-sloping aggregate-demand curve assume
that the money supply is fixed. That is, we have been considering how a
change in the price level affects the demand for goods and services, holding
the amount of money in the economy constant. As we will see, a change in
the quantity of money shifts the aggregate-demand curve. At this point, just
keep in mind that the aggregate-demand curve is drawn for a given quantity
of the money supply.

8. Functions of Money

Money has three functions in the economy: It is a medium of exchange, a unit

of account, and a store of value. These three functions together distinguish
money from other assets in the economy, such as stocks, bonds, real estate,
art, and even baseball cards. Let’s examine each of these functions of money
in turn.

A medium of exchange is an item that buyers give to sellers when they

purchase goods and services. When you buy a shirt at a clothing store, the
store gives you the shirt, and you give the store your money. This transfer of
money from buyer to seller allows the transaction to take place. When you
walk into a store, you are confident that the store will accept your money for
the items it is selling because money is the commonly accepted medium of
exchange.

A unit of account is the yardstick people use to post prices and record debts.
When you go shopping, you might observe that a shirt costs $20 and a
hamburger costs $2. Even though it would be accurate to say that the price of
a shirt is 10 hamburgers and the price of a hamburger is 1⁄10 of a shirt,
prices are never quoted in this way. Similarly, if you take out a loan from a
bank, the size of your future loan repayments will be measured in dollars, not
in a quantity of goods and services. When we want to measure and record
economic value, we use money as the unit of account

A store of value is an item that people can use to transfer purchasing power
from the present to the future. When a seller accepts money today in
exchange for a good or service, that seller can hold the money and become a
buyer of another good or service at another time. Money is not the only store
of value in the economy: A person can also transfer purchasing power from
the present to the future by holding nonmonetary assets such as stocks and
bonds. The term wealth is used to refer to the total of all stores of value,
including both money and nonmonetary assets.
Economists use the term liquidity to describe the ease with which an asset
can be converted into the economy’s medium of exchange. Because money
is the economy’s medium of exchange, it is the most liquid asset available.
Other assets vary widely in their liquidity. Most stocks and bonds can be sold
easily with small cost, so they are relatively liquid assets. By contrast, selling
a house, a Rembrandt painting, or a 1948 Joe DiMaggio baseball card quires
more time and effort, so these assets are less liquid.

When people decide in what form to hold their wealth, they have to balance
the liquidity of each possible asset against the asset’s usefulness as a store of
value. Money is the most liquid asset, but it is far from perfect as a store of
value. When prices rise, the value of money falls. In other words, when goods
and services become more expensive, each dollar in your wallet can buy less.

9 Multiplier Effect