THE CIRCULAR FLOW MODEL OF THE ECONOMY

• is a simplification showing how the economy works

• shows the relationship between income, production and spending in the

economy as a whole.

• shows the workings of an economy that is open to foreign trade.

• it includes the foreign sector.

OPEN FOUR-SECTOR CIRCULAR-FLOW DIAGRAM
PARTICIPANTS:

1. Households

• own the factors of production

• place their factors of production on the factor market so that it can be

bought.

• earn income in the form of wages by selling their factors of production to

business.
2. Business Sector

• uses factors of production to produce goods and services on which the

household sector spends their income

• place goods and services on the product market which is bought by

households to satisfy their needs

• Business receives an income.

3. State / Government

• Household sector provides the state with labour and receive income.

• The state provides the household with public goods and services (e.g.)
parks, hospitals

• Households pay taxes to the state (income for the state)

• There is a flow of money and goods and services between the business
sector and State.

• The business sector provides the state with goods and services for which
the state pays.

• The state provides the business sector with public goods and services e.g.
roads, electricity, harbours, etc.

• Business pay taxes to the state.

Foreign Sector

There is a flow of goods (imports) to the business from the foreign sector

Businesses that import these goods, pays for it (expenditure) for the business

There is also a flow of goods (exports) from the business in the country to the

foreign sector.

Businesses export their goods and services to other countries and earn money

for it (income for the business).

The relationship of the financial sector in the circular flow

• The financial sector consists of banks, insurance companies and

pension funds.

• They act as a link between households and firms who have surplus
money and others in the economy who require funds.

• The money which households and firms provide to the financial sector
is known as savings.

• Businesses can Borrow money from the financial institutions and use it
to purchase capital goods.

• This spending on capital equipment by firms is regarded as investment.

 FLOWS IN THE CIRCULAR FLOW

• Transactions takes place on markets.

• The exchange process has two components, namely:

1. Real flow: Goods and services and Factors of production.

2. Money flow: The earning of money (income) and payments that is

made.
 Real flow

• Consumers render production factors to producers and government via the factor

market.

• Producers supply goods and services via the product market to government and

consumers.

• Government provides public goods and services to consumers and producers.

Producers receive goods and services (imports) from and deliver goods and

services (exports) to the foreign sector.

 Money Flow
• Consumers earn an income for their production factors via factors market

from businesses.

• Business sector earn an income for goods and services via the product

market from consumers and government.

• Government earn an income from consumers and businesses

• Businesses earn an income for exports from the foreign sector and make

payments to the foreign sector for imports.

 THE RELATIONSHIP OF THE FINANCIAL SECTOR IN THE CIRCULAR FLOW

- The financial sector consists of banks, insurance companies and pension funds.

- They act as a link between households and firms who have surplus money and

others in the economy who require funds.

- The money which households and firms provide to the financial sector is known as

savings.

- Businesses can Borrow money from the financial institutions and use it to purchase

capital goods.

- This spending on capital equipment by firms is regarded as investment.

 EQUATIONS

Leakages

• A leakage represents the withdrawal of money from the economic cycle

(local economy)

• It does not give rise to a further round of income.

• Domestic purchases on goods and services decrease.

• In an open economy, the leakages are taxes (T), the expenditure on imports

(M) and saving.

 Injections

• represent the injection of money into the economic cycle (local economy)

• It refers to the flow of any spending which is not derived from income (Y)

• Additional money enters the economy and it increases income

• Domestic purchases on goods and services increase

• In an open economy, injections are government spending (G), the revenue

earned from exports (X) and investment spending (I).

Equilibrium

• The economy is in equilibrium when leakages are equal to Injections.

L = J

S+T+M = G+I+X
Disequilibrium

• The economy is in disequilibrium when:

1. Leakages are more than Injections (L > J).

2. Injections are more than Leakages (J > L).

1. National Income increase when Injections are more than Leakages.

J>L

G+I+X>S+T+M

• The amounts of injections which exceed leakages contribute to additional

demand.

• This additional demand must be satisfied.

• This causes an increase in the production of goods and services.

2. National Income decrease when Injections are less than Leakages.

J<L

I+G+X<S+T+M

• The amount with which leakages exceeds the injections contribute to a

decreased demand.
• Demand for goods and services drop.
• Less goods and services are produced.
• Less income for participants.
DIAGRAM: The circular flow of income and expenditure

(Adapted from: Enjoy Economics)

Mathematical and Graph Presentation
• Income (Y) is equal to Expenditure (E)

Y=E
Y = C + G + I + (X-M) = E = C + G + I + (X-M)

Mathematical Calculation
Imports (M) R40 million
Investment Spending (I) R180 million
Consumption Spending (C) R 110 million
Exports (X) R 25 million
Government Spending (G) R110 million
Calculation of the aggregate Income in the economy.
Y = C + I + G + (X-M)
Y = R110 million + R180 million + R110 million + (R25 million – R40 million)
Y = R385 million
 GRAPHICAL PRESENTATION: Expenditure and income

(Adapted from: Enjoy Economics)

• Expenditure is (E) and it is shown on the vertical axis.

• Income is (Y) and it is shown on the horizontal axis.
• E = Y and it is separated by scale line.
• It halves the 90⁰ angle into two equal portions of 45⁰
• Aggregate Expenditure (AE) = C + I + G + (X-M)
• This curve shows the amount which consumers, producers, government and foreign sector plans to spend
at every level of income.
• It also equals aggregate demand.
• The curve slope upwards and to the right.
• At an income of Y, the AE intersects the vertical axis at E.
• If planned AE increase to E1
• This means more money is injected into the economy than what are leak out.
• This cause an increase of Y to Y1.
MARKETS

• coordinate economic activities and determine prices for goods and services
 1. Goods/Product/Output markets

are markets for consumer goods and services

Goods - any tangible items such as food, clothing and cars that satisfy some human

wants or need

Buying and selling of goods that are produced in markets e.g.

- Capital goods market for trading of buildings and machinery

- Consumer goods market for trading of durable consumer goods, semi-durable

consumer goods and non-durable consumer goods

Services - non-tangible actions and includes wholesale and retail, transport and

financial markets
 2. Factors/Resources/Input markets

• Households sell factors of production on the markets:

❖ rent for natural resources

❖ wages for labour

❖ interest for capital

❖ profit for entrepreneurship

• The factor market includes the labour, property and financial markets
3. Financial markets:

• are not directly involved in production of goods and services, but act as a

link between households, the business sector and other participants with

surplus funds E.g. banks, insurance companies and pension funds

 4. Money markets

• In the money market, consumers and business enterprises save and

borrow short term loans and very short term funds

• Products sold in this market are bank debentures, treasury bills and

government bonds

• The SARB is the key institution in the money market

 5. Capital markets

• In the capital market, consumers and business enterprises borrow and

save long term funds

• The Johannesburg Security Exchange is a key institution in the capital

market

• Products sold in this market are mortgage bonds and shares

 6. Foreign exchange markets

• On the foreign exchange market, businesses buy/sell foreign currencies to

pay for imported goods and services

• These transactions occur in banks and consists of an electronic money

transfer from one account to another

• The most important foreign exchange markets are in London/New

York/Tokyo

• The S.A rand is traded freely in these markets

e.g. when a person buys travellers cheques to travel

abroad
 FLOWS

• Flows of private and public goods and services are real flows and they are

accompanied by counter flows of expenditures and taxes on the product market

• Factor services are real flows and they are accompanied by counter flows of

income on the factor market

• Imports and exports are real flows and they are accompanied by counter flows of

expenditure and revenue on the foreign exchange market

GROSS DOMESTIC PRODUCT (GDP)

• is the total value of goods and services produced in a country.

• is measured over specific time frames, such as a quarter or a year.

• an economic indicator used worldwide to show the economic health of a

country.

• Another name for GDP is: Gross Value Added

Gross National Product (GNP)

• refers to the total value of goods and services where the means of
production are owned by domestic residents.

• calculates the GDP of the country, plus any income that domestic residents
receive on investments abroad, but minus any income foreign residents
receive on domestic investments.

• refers to a nation’s economic output that is specifically produced by its

citizens.

• covers income that residents receive from abroad, but excludes income that
citizens from overseas receive from domestic investments.
NATIONAL ACCOUNTS

• measure of macroeconomic categories of production and purchase in a

nation.

• are methods of accounting used to measure the economic activity of a

country based on an agreed upon framework and set of accounting rules.

The purpose of National accounts

• Indicating the economic activity within a country

• Measuring economic growth from one year to the next

• Determining the standard of living in a country

• Comparing prosperity levels among the country

DERIVING THE NATIONAL ACCOUNT AGGREGATES

Three methods are used to calculate GDP:

• Production method - GDP (P)

• Expenditure method - GDP (E)

• Income method - GDP (I)

The Production method (value added approach / method)

• The GDP is determined by calculating the sum of the value added at each

stage of the production process.

• This method yields GDP at basic prices.

• It is the quantity multiplied with the market or production price.

The Production method (value added approach / method)

• To avoid double counting, only added values are taken.

• The value of intermediate goods and services are not included in the

calculation.

• GDP is indicated as GDP(P)

Production method R (Billions)

Primary Sector 129

Secondary Sector 316

Tertiary sector 908

Gross value added at basic prices 1 353

Plus: Taxes on production 174

Less: Subsidies on products 4

Gross domestic product at market prices 1 523

2. The Income method (approach)

• GDP measure the total remuneration earned by the owners of factors of production

within the geographical borders of a country for their services of their factors in the

production process over a period of time (year).

• It is based on factor cost.

Income method R (Billions)
Compensation of employees 680
Net operating surplus 454
Consumption of fixed capital 190
Gross value added at factor cost 1 324
Other taxes on production 34
Less other subsidies production 5
Gross value added at basic prices 1 353
Taxes on products 174
Less subsidies on products 4
Gross domestic product (I) at market prices 1 523
Primary income from the rest of the world 38
Less: Primary income to the rest of the world 104
Gross national income at market prices 1 457
Current transfers from the rest of the world 11
Less: Current transfers to the rest of the world 26
Gross national disposable income at market prices 1 442
Note:
Net operating surplus include the total value of goods and services less the
costs.
Costs consist of:
• Intermediate goods and services
• The cost of compensation of workers
• The cost of capital consumption.
Aggregate of gross income + taxes – subsidies = GDP(I) + income from the rest of the
world – income from the rest of the world = GNI at market prices
The Expenditure method (approach)

• the GDP measure the total value of expenditure (spending) on final goods and

services, at market prices, within the geographical borders of the country in a specific

period of time.

• The spending of the four spenders in the economy is added together.

• That is spending by households, business enterprises and state, on consumer

goods, services and capital goods.

Expenditure method R (Billions)

Final consumer spending on goods and services 968

Final consumer spending by the general government 307

Gross capital formation 278

Residual items 8

Gross domestic expenditure 1 545

Exports of goods and services 413

Less: Imports of goods and services 435

Expenditure on GDP at market prices 1 523

NATIONAL ACCOUNT CONVERSIONS

• South Africa uses the SYSTEM OF NATIONAL ACCOUNTS (SNA)

prescribed by the United Nations.

• GDP, GDE, and GDI has a great deal to do with the prices we use such as

nominal and real prices, prices before or after taxes.

• Indirect taxes and subsidies are the most important determinants of the end

values of the circular flow aggregates.

Basic Prices

• Indirect prices and subsidies are related to production process and not

individual products.

• With the production method, taxes on production is subtracted as a cost

and subsidies on production are added as an income.

• Taxes on production are payroll taxes (SITE and PAYE), recurring taxes on

land & buildings, Business licenses.

• Subsidies on production include employment subsidies and subsidies paid

to prevent pollution.
Factor Cost
• GDP at basic prices – other taxes on production + other subsidies on production
= GDP at factor cost (factor income).

Market prices
• Conversion of values from:

Basic prices to market prices:

• GDP at basic prices + Taxes on products – subsidies on products = GDP at
market prices.

• Factor cost to market prices:

• GDP at factor cost + other taxes on production – subsidies on production = GDP
at basic prices + taxes on products – subsidies on products = GDP at market
prices.
 Net figures

• Net operating surplus = surplus after taxes

• Net income = income after taxes

• Net fixed capital formation = After consumption of fixed capital (depreciation)

• Net exports = exports – imports

 Conversion of Domestic to National figures

• Domestic figures relate to the income and production happening within the borders
of the country.

• National figures relate to the income or production by the citizens of the country.

Example:
NOMINAL FIGURES VS REAL FIGURES

Nominal figures

• also known as nominal or money value.

• also known as national product at current price.

• Production is calculated by multiplying the volume of the final goods and

services by their prices.

• Inflation has not yet been taken into consideration.

Real figures

• also known as national product at constant prices.

• The rate of inflation as expressed by the consumer price index (CPI) has been
taken into account.

• Real values of production are the nominal values of national product adjusted
for price increase.

• Real national product is the national product express in prices which applied in
a certain base year.
THE MULTIPLIER

• shows how a small increase in spending (injection) produces a more

than proportional increase in national income.

• must always be more than 1.

• works in opposite directions.

• is the ratio of a change in the equilibrium level of income (∆𝑌) to an

initial change in the level of spending (∆𝐸)

THE MULTIPLIER IN A TWO SECTOR MODEL

The multiplier derived from the marginal propensity to consume

(mpc)

• The size of the multiplier depends on the proportion of any increase in

income that is spent.

• The larger the mpc the bigger the multiplier and the smaller the mpc the

smaller the multiplier.

• It is the money that stays in the economy.

Example:
Y = R100 000
S = R 40 000 = 40% 0,4
C = R 60 000 = 60% 0,6

• marginal propensity to consume (mpc) = 0, 6

• marginal propensity to save (mps) = 0,4

Please note:
• mpc + mps is always = 1
• mps = 1 – mpc
• mpc = 1 - mps
FORMULAE to calculate the multiplier:

Formula 1:
𝟏 𝟏 𝟏
𝜶= = = = 𝟐, 𝟓
𝟏 − 𝒎𝒑𝒄 𝟏 − 𝟎, 𝟔 𝟎, 𝟒

Formula 2:
𝟏 𝟏
𝜶 = = = 𝟐, 𝟓
𝒎𝒑𝒔 𝟎, 𝟒
Formula 3:

∆𝑌
𝐾=
∆𝐸

• I = R40 000 m and it increase to R50 000 m

• Δ I = R10 000 m: in other word investment in infrastructure and development and building
of houses

• Y = R100 000 m increase to R125 000 m

• ΔY = R25 000 m

∆𝑌 𝑅25 000
𝐾= = = 2.5
∆𝐼 𝑅10 000
THE MULTIPLIER IN A GRAPH
An increase in aggregate expenditure

• E = Original equilibrium.
• Y = Original income.
• AE = Aggregate Demand is illustrated by C + I +
G
• ΔI=ΔG
• Investment spending (I) is added.
• Total spending at each level of income (Y)
increase with the amount of Investment.
• Government Investment increase
• The AE curve shifts to AE1
• The multiplier causes that Y increase to Y1
• The AE curve (Aggregate demand) shift
upwards to AE1
Planned spending determines aggregate demand.
Explain the Multiplier effect

• The multiplier relates to how much national income changes as a result of

an injection or withdrawal such as an investment.

• Initially there is an increase in injections into the economy (investment,

government spending or export), which would lead to a proportionate

increase in national income.

• The extra spending would have knock-on effect and create even more

spending

• The size of the multiplier will depend on the level of leakages.