Circular Flow of Income

In order to develop a simple short-run model of the economy, we make the following assumptions:

·         That technical knowledge and resources are fixed in the short run

·         That there is a fixed relationship between output and employment

·         There is no international trade

·         There is no government sector; ie there are no taxes and no government expenditure

·         Firms distribute all profit to their owners (households) immediately when it is earned

·         All investment is carried out by firms

·         All prices are constant, so that any change in numeric GNP is caused by a change in real GNP.

Firms produce all consumption goods and services, which are purchased by households. Households own all factors of production (resources) – labor, land, capital goods, etc. – as well as the firms themselves. This results in a circular flow of income.

The national output (GNP) is the flow of all final goods and services in an economy within a given period. The Net National Product (NNP) is GNP less depreciation, or in other words the level of output above and beyond that which would be required simply to maintain the existing stock of capital goods. In calculating GNP and NNP, only final goods and services are included. Intermediate goods, which is to say goods that are used in the production of other goods, are not included, because otherwise double-counting would occur.

GNP can be calculated in three different ways:

·         By finding the total expenditure on final goods and services

·         By finding the value added by each producer

·         By finding the total income earned by each factor of production

In practice, it can be quite difficult to make the determination between final and intermediate goods. The second method may be easier because it only requires knowing the value of output and the value of factor inputs for each firm in the economy. The final method is perhaps the easiest, since it is a simple sum of all household incomes.

Inputs to production include primary factors and intermediate goods. Intermediate goods are those factor inputs that were produced in the current period. All other inputs used in the current period are primary factors. Labor input is a primary factor, as are (most) buildings and machinery. The income paid to owners of primary factors must be financed by a firm’s sales and are normally classified as:

·         Wages and salaries – paid in exchange for the use of labor services

·         Rent – paid in return for the use of land and capital goods not owned by the producer

·         Interest – paid to the households who have loaned money to purchase land and capital

·         Gross profits – residual money accruing to the firm after payment has been made to all other factors, usually distributed in the form of dividends to the households that own the firm

The sum of payments by a firm for primary factors and intermediate goods will equal the firm’s reciepts from sales. As a result, the value added by the firm is equal to the sum of payments to primary factors, because this will equal sales (total value of production) less payments to intermediate goods (value that came from somewhere else). Since GNP equals the sum of producers’ value added, GNP is also equal to the sum of producers’ payments to primary factors of production (GNP=GNI).

The equivalency between GNP and GNI depends on the definition of profits as a residual amount obtained after deducting the value of all other inputs to production; and on the assumption that all profits are immediately distributed to households. In the real world, these assumptions may not hold.

Given that GNP=GNI, it follows that the income received by households must be just sufficient to purchase all output produced by the economy. It would seem that by the act of establishing a firm and producing output, sufficient income must thereby be produced so that the firm’s output can be paid for. While this is true, it is not guaranteed that this new income will result in effective demand for the firm’s goods. Some income might not find its way into expenditure at all, at least in the short run.

The level of output that can be sustained is therefore dependent on the level of expenditure or effective demand. Potential output sets the limit to the level of income and expenditure possible, but actual output may fall short of this limit. The short run theory of income determination sees acual output as dependent on effective (aggregate) demand.

Households engage in two activities, consumption and savings. Consumption (C) consists of expenditure on goods and services to satisfy current needs or wants. For the purpose of this simple model, we shall ignore the problems raised by consumer durables (like cars), which yield a flow of services over time. Savings (S) is whatever income is left over after C. It follows that gross national income (GNE aka Y) = C+S.

Firms also engage in two activities, investment and production. Production occurs to satisfy the consumption demand of households and is in equilibrium only when it is equal to that expenditure, so it is also represented by the symbol C. Investment is the production of goods and services which are not used for consumption purposes. There are two main categories of investment: Inventory and capital goods. Buildup of unsold inventory is a form of investment; reduction in inventory is a form of disinvestment. Some investment in capital goods is required just to maintain current levels of production, but additional investment over and above this amount will result in increased productive capacity in the future. Investment expenditure is given the symbol I. Total output will equal C+I. Total output is GNP, which is equal to Y, so: Y=C+I.

If Y=C+I and Y=C+S it follows that I=S. Investment and savings are defined in such a way that they must be equal. This does not mean that planned saving always equals planned investment; quite the contrary. However, by the definitions of the model, actual savings is the amount of money that will be available for acual investment and thus the two will be equal. If planned investment is lower or higher than planned savings, firms will find themselves encountering an unplanned investment or disinvestment.

If all income were consumed, then all value added (output) would accrue to private households through factor incomes, and all factor incomes would be used by households to purchase consumption goods and services from firms. In such an economy, supply would create its own demand, as all income would be consumed. There would be no withdrawals or injections to the circular flow of income, so that any flow of national income would continue in an indefinite equilibrium, with no tendency for GNP (or GNI or GNE) to change. This of course assumes a fixed capacity output, but this is a short-run model. In reality, if all income were to be consumed, the stock of capital goods would decline and output would be reduced.

In practice, most economies save and invest a proportion of national income, as shown in the diagram above. Savings are not passed on in the circular flow of income, but constitute a withdrawal from it. In other words, savings do not constitute a component of aggregate demand, because the act of saving does not generate a demand for current output. Investment, on the other hand, is an injection into the circular flow of income. It is part of aggregate demand because the act of investing (buying more capital goods) does indeed generate a demand for current output.

Any withdrawal has a contractionary effect on the level of national income. Any injection has an expansionary effect. Equilibrium can only occur when the contractionary and expansionary effects are in balance, or in other words when there is consistency between the savings plans of households and the investment plans of firms. If planned savings and planned investments are equal, the economy will be in equilibrium. If they are not equal, the economy will be in disequilibrium and must expand or contract until the plans again come into balance. In the equilibrium diagram above, households elect to save 10% their income. If households change their plans and choose to save twice that amount (20%) then the economy will be in a contractionary disequilibrium:

Under these conditions, and if there are no changes to the planss of investors or savers, national income will fall. In the earlier, equilibrium model, aggregate demand (Y) was equal to $100 billion, equal to C ($90 bln) + I ($10 bln). Now, C has fallen to $80 billion with I unchanged at $10 billion, resulting in aggregate demand (Y) or $90 billion. The sales reciepts of firms will have fallen accordingly. As a result, firms will not be able to sell all the output produced, so there will be an unplanned increase in inventories. Inventories will continue to increase so long as output is maintained at the original level. Soon, firms will react by reducing the level of output. Assuming that firms  continue to plan to invest $10 billion, and households continue to plan to invest 20% of their income, a new equilibrium will be established:

The result of Y=$50 billion is a result of the savings plans of households. If firms output Y by a lesser amount, say to Y=$70 billion, then households will plan to save $14 billion, which is still higher than the investment plans of firms. A new equilibrium will not be reached until the savings plans of households again equal the investment plans of firms. There is a multiplier effect in evidence here: A change of $10 billion in the savings plans of households has caused a change of $50 billion in GNP.

The motives for households to save and for firms to invest are quite different. Households save so that they can buy expensive goods in the future, or to protect against becoming unemployed, or to leave wealth for their children, or through sheer miserliness. Firms invest in the expectation of profits, and the volume of investment is clearly a function of the availability of profitable investment opportunities. But even when investment opportunities are poor, households will still wish to save. Because of these divergent motives, there is no guarantee that the plans of savers and investors will be consistent, even in the short run with which this model is concerned. For this reason, the level of national income realized can and does depart from full employment income.