a sum ofallineome, sum of values of all final production, and sum of all expenditures will ie sme, but the significance of each arises from the fact that they reflect the three asic activities o jon’s economy, viz., prod |. distribution and expenditure. CIRCULAR FLOW OF INCOME ‘The modern economy is a monetary economy, In the modern economy, money 1S. used a the rocess of exchange. Money has facilitated the process of exchange and has removed the difficulties parter system. Thus money acts as a medium of exchange. The: households supply the economic efi in the payments in terms of money. Il to the flows 9 Circular Flow of Income and National Income Accounting sal nat ofthe eye Creources oF factors to the productive firms and receive in retu fc hus clear that, in the monetary economy, there will be flows of money corresponding df economic resources and the flows of goods and services. But each money flow is in opposite direction to the real flow Circular Income Flow in a Two Sectors Economy Real flaws of resources, goods and services have been shown in Fig. 2.1. In the upper loo} figure, the resources suchas land, capital and entrepreneurial ability flow from! households to business firms as indicated by the arrow mark. In opposite,directian 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 oon the goods and services services produced by the firms, while the flow of goods and services is in p of this and, Capital & Ente papoe hand Copiel & Eeprise es, Reml Interest Prof, wat! z é C ‘°nsumption Expendue’® ION oT Gods aed Se Fig. 2.1. Circular Flow of Income in a simple two sector Economy 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 Eberle fc ofr ox tno, Tides Tgp vil onions eas 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, ee 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 andwiltheefore change withchangesinshenational 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.- en Llacroeconomics Theory & Policy In order to make our analysis simple and to explain the central issues involved, we tay. assumptions. Inthe first place, we assume that neither the households save from their ine ke the firms save from their profits. We further assume that the government does not play any par, vad Rational economy. In other words, the government daes nat receive any money from the ‘way of taxes, nor does the government spend any money on the goods and services produce cst firms or on the resources and services supplied by the households. Thirdly, we assume thy he thy, €conomy neither imports goods and services, nor exports anything. In other words, in ourgdfour 4 analysis we have not taken into account the role of foreign trade. In fact we have explained a ‘ aboyg flow of money that occurs in the functioning of a closed economy with no savings and no le} "0 ro Circular Money Flow with Saving and Investment In our above analysis of the circular flow of money we have assumed that all income whigg « which houscholds receive, they spend iton consumer goods and services. Alresult, circular flow. Of ag OF speeding and income remains undiminished. We will now explain if households save-a; Tro income, how tbeir savings will affect money flows in the economy. When hauseholds save, pe ave, ‘expenditure on goods nd services will decline to thatextent and asa result money flow tothe buss: bu firms will contract. With reduced money receipts, firms will hire fewer workers (or lay off amy off, workers) onreduce the factor payments they make to the suppliers of factors such as workers. Ty cers. will'lead to the fall in total incomes of the househalds, Thus_savings reduce the flow of moe of expenditure to the business firms and will cause a fall in economy's total income. Econanja therefore call savings a leakage from-ihe money expenditure flow. But savings by households need not lead to reduced aggregate spending and income if they fm they their way back into flow of expenditure. In free market economies there exists a set of instituting stituti such as banks, insurance companies, financial houses, stock markets where households deposi the osit savings. All these institutions together are-called financial institutions or financial market. We assume 2 that all the savings of households come in the financial market. We further assume that there arm re inter-households borrowings. 7 = pastor Parmeny Fig. 2.2. Circular Money Flow with Saving and Investment ness firms who borrow from the financial market for investment in capital goods sub factories. tools and instruments. trucks. Firms spend on investment in order to €X jyctive capacity in future. Thus, through investment expenditure by borrowing the savil® olds deposited financial market. areagain brought into the expenditure steam and Iris busi machines: their prod of the houselCircular Flole of tncome and National Income Accounting 21 a result total flow of spending does not decrease. Circular money flow with saving and investment is slustrated in Fig. 2.2 where in the middle part a box representing financial marketiis 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!. Condition for the Constaney of Circular Money Flow Now the question arises what is the condition for the flow of money income to continue at a steady level so that it makes possible the production and subsequent flow of a given volume of goods and services at constant prices. To explain this we have to introduce saving and investment in the analysis of circular flow of income, As mentioned above, saving a part of income means it is not spent on consumer goods and services. In other words, saving is withdrawal of some money from the income flow. On the other hand, investment means some money is spent on buying new capital goods ‘o expand production capacity. In other words, investment is injection _of some money in circular flow of income. For the circular flow of income to continue unabated, the withdrawal of money from the income stream by way of saving must equal injection of money by way of investment expenditure. Therefore, planned savings must be equal to planned investment if the constant money income flow in an economy's to be obtained. Now, what will happen if planned investment expenditure falls short of the planned savings? As a result of fall in planned investment expenditure, income, output and employment will fall and therefore the flow of money will contract. If the equality between planned savings and planned investment is disturbed by increase in savings, then the immediate effect will be that the stocks of goods lying in the shelves of the shops will increase (as some of the goods will not be sold due to the fall in consumption ie., increase in savings). Owing to the deficiency of demand for goods and the accumulation of stocks, retailers will place small orders with the wholesalers Censequently, smaller amount of goods will be produced and therefore fewer capital goods like machinery will be indeed with the result that fixed investment will tend to fall. Thus the ultimate effect of either the fall in planned investment or the increase in planned savings is the same, namely, the fall in income, output, employment and prices with the result that the flow of money will contract. —_On the other uality between planned savings and planned investment is disturbed by the increase in investment demand, the result will be increase in income, output and employment. Consequently, the flow of money income will expangh Itis thus clear from the above analysis that the flow of money income will. continue at a constant level only when the condition of equality between planned saving and investment is satisfied. It was belicved by classical economists that financial market provides a mechanism which coordinates the savings of households and the investment expenditure, by the firms. Rate of interest, which is the price for the use of savings, is determined by saving and investment. If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of interest, investment increases and both become equal. On the contrary, if investment expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest savings increase and become equal to planned investment expenditure. However, an eminent British economist J.M. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. According to him, since in a free market capitalist economy, investment is made by business enterprises and savings are mostly done by households and for different reasons, there is no guarantee that planned investment will be equal to planned savings and thus fluctuations in income, output and employment are inevitable. As a |. It may be noted that business firms also save when they do not distribute among shareholders all the profits made by them and keep the undistributed profits as reserves. We are ignoring them Ih our money flow analysis as firms themselves use their savings for buying machinery and making other investment expenditure. acter —af Macroeconomics Theory & Policy a steady level in a free-enterprise result, circular flow of income does not continue at taken by the government to economy unless certain corrective and preventive steps ate. Stability in the economy, Pade Saving-Investment Identity in National Income Accounts different from the business firms which primarily, Despite the fact that people who save ar in national income accounts savings are identical or always equal to investment ina simple Wo seg, economy having no roles of Government and foreign trade. This is a basic identity in national inggy accounts which needs to be carefully understood. Of course, in our above analysis of circular fgg income, we explained that planned investment by business firms can differ from savings by househ But in that analysis we referred to planned or intended investment and savings which often differ affect the flow of national income. However, in national income accounts we are concered wg actual saving and actual investment. It is these actual or_realised saving and investment that identical in national income accounts. We can prove their identity in the following way. In a simple economy which has neither government, nor foreign trade, the value of ou produced which we denote by Y is equal to the value of aufput sold. Since the value of output soldi, a simple two sector economy is equal to the sum of consumption expenditure and investmey expenditure we have EL Yac+l ‘ sl) where Y= Value of aggregate output, C= Consumption expenditure and / = Investment expenditure, ‘A pertinent question which arises here is what happens to the unsold output. The unsold outpa leads to the increase in the inventories of goods and in national income accounting increase it inventories of goods is treated as a part of actual investment. This may be considered as the fim Hing the to ir inventories. Thus, gross national product (GNF) produced is used either for consumption or for investment. 1 Now, look atthe gross national product or income in the simple economy from the viewpoint ofits allocation between consumption and saving, Since national income (which is equal to GNP) canbe either consumed.or saved,'. We have PeCtS Datorvk Meu well) From the identities (i) and (i) we get é C+InYaC+s wa ‘The left hand side of the identity (iii), namely C + J = Y shows the components of aggregal and (that js, aggregate expenditure on goods and services produced) and the right-hand side of the identitiy (if) namely Y= C+ S shows the allocation of national income to either consumption saving. Thus, the identity (ii?) shows that the value of output produced or sold is equal to the tot income received. It is income received that is spent on goods and services produced. Now subtracting the consumption (C) from both sides of the identity (ii) we have ames > “Thus, in our two sector simple economy with neither government, nor foreign trade, investmett ically equal to saving, ae | wns about saving are made both by households and business firms. In national income \. re generally put together and referred t0 as private sector savings, |Circular Flow of Income and National Income Accounting 23 Circulr Income Flows in three Sector Economy with Government Sector {n our above analysis of money flow, we have ignored the existence of govémment for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes eared 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 soods, and on education and public health and so on. These add to the money flows which are shown in Fig. 2.3 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, “ton << “Seas on Oo Fig. 2.3. Circular Money Flow Model with Government 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. 2.3 This money flow includes all the tax payments made by households less transfer payments re- ceived from the Government. Transfer payments are treated as negative tax payments. Another method of financing Government expenditure is barrawing_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 cet 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 expendi- ture (denoted by C),, investment expenditure (/) and Government expenditure (denoted by G). Thus Total expenditure (E)=C +/+G 0 Total income (¥) received is allocated to consumption (C), savings (S) and taxes (7). Thus Y=C+S+T 2 (ii) Since expenditure(£) made must be equal to the income received (¥), from equations (i) and (ii) above we have ae sie+ } } 1 e Macroeconomics Theory & Policy 4 f C+I+G =C+S4+T Since C occurs fi cancelled out, we ‘ and will therefore be cance| 7. i ides of the equation (iii) an c on both si ee a ing we obtain al | G-T=S-1 a 8 if, Equation (v) is very significant as it depicts what Se fgovernen isnot balanced. If Government expenditure (G) is greater than the tax ie hae ‘sg Fone ent will have a budget deficit. To finance the budget deficit Govern from the financial market. For this purpose, then private investment (J) by business firms my Tess than the savings(S) of the households. Thus Government borrowing reduces private inye, inthe-economy. In other words, Government borrowing crowds out private investment, Another important conclusion that can be drawn from national income account identity in, rating Government expenditure relates to the condition for equilibrium in the financial National income identity with government exper or In the expression (vi), the lefthand side (Y — C- © represents national saving or simply say (9). Note that in this National Income Identity all government expenditure is treated as consump caPenditure. To understand the identity vi), we break Up its left hand side representing saving into two parts, namely, ©) private saving (Y — T~ C) and (2) public saving (i.e. saving of government (7— G), Thus a ty ’ S=(-T=0)4(T-G)=¥-c_G (Note that ¥— Tis disposable income) fe fe cava) toremain ina steady state, the lows into the financial market (i.e, private sav and public saving) must balance the flows out of the finance market, Thi ideemeees ZONS out of the financial us, For the economy Y-T-C+(7-@=] That is, for the economy to remain in a steady state, the ‘sum of prive i Public saving must equal investment, Money Flows in the Four Sector Open Economy : Adding Foreign Sector We now tum to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Thus, the inclusion af the foreign sector will reveal tus the interac. tion of the domestic economy with foreign countries. Foreigners interact with the de ‘mestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. Goods and sery.EIS EA Circular Flow of Income and National Income Accounting 1s called imports. Figure 2.4 illustrates additional money flows that occur in the open economy when exports and imports also exist in the economy. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and Import goods and services, A flow of money spending on imports have been shown to be occurring from the domestic business firms to the foreign countries (i.e, rest of the world), On the contrary, flow of money expenditure on exports of a domestic economy has been shown to be taking place from fore cign countries to the business firms of the domestic economy, If exports are equal to the Imports, then there exists a balance of trade, Generally, exports and imports are not equal to each other. If value of exports exceeds the value of imports, rade surplus occurs, On the other hand if value of imports exceeds value of exports of a countty, ‘rade deficit occurs, tn the-open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. These days financial markets around the world have become well integrated, When there is a trade surplus in the economy, that is, when exports (X) exceed imports (1M), ner capital outflow will take place. By net capital outflow we mean foreigners will borrow ftom domestic savers to finance their purchases of our exports. In this way as a result of net capital outflow domestic savers will lend to foreigners, that is, acquire foreign financial assets On the contrary, in-case-of import surplus, that is, when imports are greater than exports, trade deficit will occur. ‘Therefore, in case of trade deficit, domestic consumer households and business firms will borrow from abroad to finance theit excess of imports over exports, ‘This means there will be capital inflow in our economy, As a result, foreigners will acquire domestic financial assets, Saving-Investment Identity in the Open Economy From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net of exports, that is, XM where represents exports and M represents imports. Imports must be subtracted from the total expenditure made by foreigners on our domestically produced goods and services exported to them to get the value of net exports. Thus, in the open economy National Income=C+/+G+NX —. where NX represents net exports, XM. Since national income can be either consumed, saved or ‘paid as taxes to the Government we have. i C+I+G+NX= CHEE Since C is common on both sides of the above equation we have (Ces +T) (vi) The above equation (vi) shows that in the open economy sum of private investment (/), Govern- ment expenditure (G) and net exports (VX) is equal to the sum of savings and nue. Relation of Aggregate Domestic Output and Expenditure with Trade Balance, The national income account identity of the open economy can be used further to show how aggregate domestic output (Y) and aggregate expenditure (C + / + G) and net exports (i.e. trade balance) are related. Rearranging the national income of the open economy (Y= C +/+ G+ NX) we have NX=Y¥-(C+1+G) Where C+ J+ G is aggregate domestic expenditure. Thus Net Exports = National Domestic Product (Y) ~ Aggregate Domestic Expenditure From above it follows that in an open economy aggregate domestic expenditure neednotbe equal. to the aggregate domestic output of goods and services (i.e. ¥). If aggregate domestic output (1) ex o ic expenditure (C + + G), we export the excess of domestic output, that Freee Fi tes a ETIBES FOR Ee hen, if domestic output is less than domestic expenditure we import this shortfall (i.e. NX <0). Foreign Capital Flows and Trade Balance. As in the case of a closed economy goods marketUU ———— ts—“_O s Theory & Policy a Macroeconomics The To show this, let us rearran Ane tntimately related tothe financial market inthe PREY athe then deonoty. Rational income accounts identity (Y ~ aa mi " p i eS ional saving (S), yy, ‘ nts natio ig The left hand side of the above equation (ie. Y~C—G) represe ‘i jiture. Thus, it follows from aj all Government expenditure is here treated as consumption expend that Seon (vi S-1=NX Wi ot * ec y's net exports (N; ‘The national income identity of expression (vil) Ne ee eae export Pa oa always be equal to the difference between Saving and inves conan wade balance because it, shows the difference between exports ap ae fe “ ae Theta balance (x) may be positive or negative, Ifexports exceed imports, tra POsitiyg and if exports fall short of imports, the trade balance (VX) is negative. But the important result that follows from national income identity of the open economy re tothe link in (viii) is positive, lending the excess fing net capital outflow from the economy. On the other hi borrowing from abroad to fi the economy to finance hi 'sher capital formation inthe economy, 1 follows from above that net capital flows (S ~ 1) always equal the trade balance Sccount balance which is the broader term that includes invisibil are wages for the e the work, of production, ‘stent because of their, Contribution of land tothe productive m zt 8 their money capital to the entre any work of production or business, Thee : Preneurs for undertaking , - Theentrepreneurs get pron mf of Production and bearing risk and Uncertainty involved a naBand organising the work individuals ofa country obtain thei inears either as a I orasr S Clear th; ifferent BES of their labo — Jani fits for their ent ". OF as interest on theit ‘5 wages, rent, interest and profits is the ational income ofthe Thesum of incomes obtained land cpt naeaa et came tomtepene ag labour, land, capital and other Services for the i man tsinesses which utilise theif Production of 's Which utilise thei by the various households and individuals from the work of eos and Md Services. The i Ork of F '¢ incomes earned ofthe goods produced. The total value ofall B0odsaneP*ducton N fact costs, Of production Se eee ama orah ona Product. Therope' Produced Various productive can be estimated by multiplying the wong OUrPULOF Final goods gyre Mai Hence the total national-prodyes sy Product ofa country , tems of rupee mens With their market prices. ii 5 istrit Which j, a ‘oductive firms in a year, Thee tte amen tS Produced by various Soitrbtned to its production seTfore, ou ofthis ational aa or (net factors whichehinie Read eas hae ea lathe lbourig roductiye Value terms) ill “ of the national product; an mld Bt rent for the ¢ ibution of th Out ofthis total value services of land and