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Dr Robin Nunkoo
Associate Professor
University of Mauritius
r.nunkoo@uom.ac.mu
Introduction
Macro-economics is concerned with the workings of
the whole economy
An economy is a complex structure
Disagreements among economists about whole the
economy works
Nevertheless, there is an accepted general model
of economic behaviour
The circular flow of income
The Circular Flow of Income (The
Simple Model)
The Circular Flow of Income (The
Simple Model)
Household: Own wealth of the nation: land, labour,
capital used to produce goods and services
They supply these factors to firms in return for
wages, rent, interests, and profits (Rewards)
Firms produce goods and services
They hire the factors of production from household
and use these to produce goods and services
Household uses the money to purchase goods and
services
The Circular Flow of Income (The
Simple Model)
This is a very simple representation of the workings
of an economy
It assumes that household spends all their money on
goods and services
Firms spend all their revenues on factors of
production owned by the firms
There is no government- hence no government
spending (G) and taxes (T)
The economy is closed
The Circular Flow of Income (The
Simple Model)
The amount of money flowing in the economy gives
value to the level of economic activity
This can be measured in three different ways
Expenditure (E): spending by households on the
goods and services produced by firms
Output (O): the output of the firm (i.e. the value of
what they produce)
Income (Y): the income paid by firms to household
The Circular Flow of Income (The
Simple Model)
In national income accounts, the three are identical
because they are defined in such a way as to be
identical.
Thus, we derive the following equation:
O=Y=E
The Circular Flow of Income (The
Complex Model)
The Circular Flow of Income (The
Complex Model)
The Circular Flow of Income (The
Complex Model)
In the simple model, it was assumed that households
spend all their incomes
However, this is unlikely to be the case
A proportion of the income constitutes savings (S)
Savings is a withdrawal because money leaks out from
the circular flow
More so, firms do not spend all their money on existing
factors of production
They spend money on investment goods such as
machines, equipments, factors, etc.
These are known as injections in the national economy
The Circular Flow of Income (The
Complex Model)
In the real world, savings and investment are linked
through the financial system.
Households save their money in banks who in turn
lend this money to forms to finance investment
The Circular Flow of Income (The
Complex Model)
Government exists in all economies
Government raises money through taxes to finance
public spending on defence, health, education,
social security, infrastructural developments, etc.
Taxes represent a withdrawal of money from the
circular flow of income
Government spending on the other hand, constitutes
an injection in the circular flow
The Circular Flow of Income (The
Complex Model)
It is unrealistic to assume that an economy is self-
sufficient
Nations engage in international trade in goods and
services
Consumers spend money on imported good
Imports (M) are therefore a withdrawal from the
circular flow of income
Exports constitute an injection in the circular flow of
income
The Circular Flow of Income (The
Complex Model)
In the circular flow of income, injections must be
equal to withdrawals
To understand this, it is important to introduce two
identities
An identity in economics is something which is true
by definition
For e.g. quadrupeds have four legs because by
definition, quadruped means four legged animals
by definition
The Circular Flow of Income (The
Complex Model)
Households either spend their income on
consumption expenditure (C) or savings (S), then
Y=C+S
We also assumed that there were two components
of total spending on goods and services
Households spend on goods and services while firms
spend on investment, then
E=C+I
The Circular Flow of Income (The
Complex Model)
Income (Y) and expenditure (E) are two ways of
measuring national income, then:
C+S=C+I
It must therefore be true that
S=I
Government spend money collected in the form of
taxes, then:
I + G = S + T