8. Measuring the Performance of the Macroeconomy, the Flow of Incomes
8.2. The Circular Flow of Incomes in the Macroeconomy, Equilibrium Conditions
The flow of incomes in the four-sector model consist of the interactions between firms, households, the government and the rest of the world, and these flows among the four sectors take place through the goods market and the capital (financial) market, or directly from one sector to the other. The goods market represents the market for final goods – products and services for consumption and not for further processing (but including investment goods, too).
The following notations will be used to describe the flow of incomes:
Y: Total national income, Q: (total ) output
W: Wages (and all other factor earnings paid by firms to households)
C: Consumption, I: Investment;
G: Government expenditures;
X: Export; IM: Import
S: Savings; SF: Savings by Firms; SH: Savings by households; SW: Savings by the rest of the world; SG: Savings by the government (the state budget)
T: Taxes; TF: Taxes paid by firms; TH: Taxes paid by households
TR: Transfers; TRF: Transfers paid to firms; TRH: Transfers paid to households.
Figure 8.3: Cirular Flows of Incomes in the Macroeconomy
Note: for ’lows of goods and money’ the arrow points to the direction of money flow, while goods flow into the opposite direction
Source: Author’s own construction
The sector of firms produce the total output of the macroeconomy, that is, the total quantity of final goods, and sells these goods in the goods market. The total value of these final goods gives the total income (Y) of the macroeconomy, which is the incoming flow of money into the sector of firms. The firms will use this income to pay for the factors of production purchased from the household sector, the most important of these being labour, for which the firms pay wages (W). (Really, the firms pay the primary income of households not only for labour, but all other productive resources including rent for land and other natural resources either rented or purchased, for dividends or interests for the savings of households invested in the firms as capital. For the sake of keeping the model as simple as possible, all these factor incomes will be incorporated into the value of W). Productive resources purchased from other firms are intermediate goods, therefore the value of these inputs are already included in Y – which contains the value of all final goods, including investment goods. The values of intermediate goods are flowing between firms within the sector, not causing any inflows to or outflows from the sector of firms. The firms have to pay tax to the government (TF), and they may receive transfers (TRF) from it – e.g. subsidy for introducing environmentally safe investments. The difference of the sum of inflows to the sector and the sum of outflows from it is the savings (SF) of the sector, which the firms will deposit in the financial market – e.g. puts it into a bank, or, borrow from it, when SF is negative.
The main income source for households is the wages and other factor incomes received from the firms (W). A part of this income is paid to the government as tax (TH), although they may receive transfers from the government (TRH) as well – maternity benefits, unemployment allowances, grants, etc.. The income left with the households after paying taxes and receiving transfers will be spent on purchasing consumer goods in the goods market (C), or saved (SH), and deposited in banks (in the financial market).
The govenrment (the sector of the state) earns its revenues by collecting taxes from the firms and households (TF and TH), although a considerable part of these taxes are paid back to
these two sectors as transfer payments. The rest of the government revenues is spent on government expenditures (G) – covering the costs of maintaining and running the government administration -, spent on products and services sold in the goods market. If the goverment revenues were higher than the amount spent on transfers and government expenditures, then the state would save the remaining money (SG), and would deposit it in the banking system. In the real world there are hardly any countries with positive government savings. Most of the governments spend more than they collect as tax revenues, so the value of SG is usually negative, and instead of depositing its savings the government takes loans from the bank to cover the deficit, absorbing a considerable part of the private savings deposited in the banks.
The fourth sector of the economy is the ’rest of the world’, which sells its own products for our national economy, which is our import (IM), and purchases goods and services from our economy, which is our export (X). When the export and import values are equal, then our goods market still contains the same value of goods as produced by the firms in our national economy (Y), although its composition is different. If import is higher than export, then our goods market contains more goods for home consumption than our own production, but the income left at the economic agents of our country is less than Y (because more money was paid for imports than received for exports). Therefore the residents of our country would spend more on consumption than their income, while the rest of the world, owns more income than the goods available in their market for consumption. Thus, the rest of the world saves the unspent income (SW), and offers it as a loan for our economy, our country takes this loan and then spends it in the goods market. This means that the saving of the rest of the world is equal to the difference between import and export. Naturally, when out import is less than our export, our country will spend less than its income, so our country provides loans for the rest of the world, and the saving of the rest of the world is negative. The difference X-IM is also called net export (NX).
Finally let’s consider savings accumulated in the financial market. The sum of these savings – that is, the balance of positive and negative values – reflects the share of national income not spent by the economic agents in the goods market, so this is the share of Y left after spending C, G and X-IM. When the sum of savings is positive (SF+SH+SG+SW > 0), then the value of Y is larger than the sum of C, G and X-IM, therefore there must be some goods left in the goods market not included in the above three items. These goods are the investment goods (I) purchased by those wanting to invest in productive capacities, using the savings of the economic agents.
Now we have described the flows of income in the macroeconomy. For each sector of the economy the inflows and outflows of incomes can be written in the form of ’T-accounts’, to get the so-called current income accounts, and similar accounts can be defined for the goods market (national income account) and the financial market (financial account).
Table 8.2: Income identities for the owners of the incomes Firms Households Government Rest of the
world
The financial account is worth of special attention, because it states that the total value of investments in an economy must be equal to the sum of the savings of the four sectors, that is, the savings of the domestic and foreign economic agents. Consequently, a high deficit of the state budget (a negative value of SG ) will absorb a large amount of the private savings, leaving only a small financial capital available for investments, that is, for improving the future productive capacity of the economy.
The national income account describes the equilibrium condition for the goods market, which – in a sligthly rearranged form - is called the national income accounts identity:
Y = C + G + I + X-IM
This equation may be interpreted as the equality between the amount of goods supplied by, and the amounts of goods demanded by the four sectors of the economy, and also as an income equality, with Y on the left-hand side being the source of all incomes in the economy, and the various purposes of spending this income on household consumption, government expenditures, investment spending, and net export on the right-hand side.
Table 8.3: Macroeconomic indicators for selected developed countries, 2008
Hungary Germany USA China GDP, current prices, billion USD 154.2 3623.7 14219.3 4521.8 GNI, current prices, billion USD 129.3 3491.3 14561.6 4030.7
C – Household consumption, as a % of GDP 55 56 71 35
I – Gross investment, as a % of GDP 22 19 18 44
G –Government expenditures, as a % of GDP 22 19 16 13
X – Export, as a % of GDP 82 48 13 35
I – Import, as a % of GDP 81 42 18 27
Total national debt, as a % of GDP 74.3 43.1 55.5 - Source: Author’s own construction based on data of World Bank Data and Statistics and the website of KSH
(http://econ.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/, and http://www.ksh.hu/docs/hun/eurostat_tablak/, accessed: 21st 09. 2012.)
Review Questions
1) Describe the indicators of SNA, explain the difference of ’domestic’ and ’national’
indicators.
2) Define the following indicators: GDP, GNI and GNDI.
3) Sketch the circular flow of incomes in the four-sector model of the national economy.
4) What do the current income accounts mean?
5) Write the ’national income accounts identity’, and explain its meaning.
Problems and Questions to Develop Competence
1) Collect data of Hungary and at least two other countries for GDP, household consumption, government expenditure, investment, export and import in the last 5 years (use the newest available data). How is the GDP spent? What percentage of it went for C, G, I, and
X-IM? What similarities and differences may be pointed out between Hungary and the two other countries?
2) The following data are known about the economy: Y = 3500, C = 1800, W = 2500, I = 1000, SF =800, SG =40, TF = 280, TH = 580, X = 40, IM = 45. Calculate the following indicators:
a. government expenditure: G = ?, b. household saving: SH = ?
c. transfers paid to firms: TRF = ?, d. transfers paid to households: TRH = ?
Write the current income accounts for the four sectors of the economy and explain the meaning of the notations.
3) What are the impacts of the following events on the value of real GDP? Will the change of real GDP cause the same change in the welfare of the country?
a. A hurricane in Florida makes Disney World shut down for a month.
b. The discovery of a new, easy-to-grow variety of wheat increases the harvested yields of wheat.
c. Increased hostility between unions and management of corporations leads to a series of strikes.
d. Firms throughout the economy experience falling demand, causing them to dismiss workers.
e. The Parliament passes new environmental laws that prohibit firms from using production methods that emit large quantities of pollution.
f. Many high-school students drop out of school to take jobs mowing lawns.
g. Fathers around the country reduce their workweeks to spend more time with their children.