Economy Leakages Money
Question 1 "The circular flow model shows how real resources and financial payments are exchanged between firms and households." (Begg, Fischer & Dornbusch) (a)Explain this statement. (b)Draw the circular flow model of an economy. (c)Define leakages (withdrawals) from the circular flow. (d)Define injections into the circular flow. (e)Explain how equilibrium is achieved in the circular flow.
Question 2 Using appropriate IS/LM diagrams show: a)How equilibrium income and the interest rate are determined in a closed economy. b)How an increase in government spending can affect equilibrium income and interest rate. c)What is meant by "crowding out"?
Question 1
a) The circular flow model of the economy shows the path of money between consumers and producers (or, more practically, households and firms). Goods and services (real resources) are traded for financial payments in both directions; households pay firms in exchange for goods and services, and firms pay individuals in exchange for labour in production. The same money which is paid in wages is returned to firms when buying their goods, making a constant flow of exchange; money flows are therefore not ‘real' resources as they are not consumed and can be used again. The use of the term ‘households' rather than simply ‘consumers' takes account of the fact that not all consumers earn wages themselves (for example, unemployed dependent children), so wages are spent by groups rather than workers.
b)
Households
Firms
Injections
Leakages
Payment
Labour
Goods
Wages
c)‘Leakages' are manners in which money is removed from the economy, preventing it being exchanged again for goods. In this case the leakages are due to household saving, purchasing imports and arguably through taxation.
Money which households save is not available to be exchange again, leading to what Keynes called “the paradox of thrift”- although it seems beneficial for an individual to save, if everyone were to follow aggregate incomes would fall.
Importing detracts from the flow because the money exchanged for the goods will not be given as wages to domestic workers. Over-reliance on imports can severely reduce national income.
Some income is removed by taxation, preventing it being spent directly on consumption. Not all diagrams include this however, as theoretically all government money is reinvested into the economy.
d)‘Injections' are manners in which the total money supply in the economy is increased; these are from selling exports, from investment and from government spending.
Selling exports brings in extra foreign money. Foreign direct investment is also an injection, although it is worth noting that it may later reduce the flow if funds are removed with interest or dividends.
Investment- the accumulation of capital not consumption goods -increases the flow by adding real resources for future consumption. Investment often comes from governments as a result of tax revenues; however, because government injections do not always correlate with government taxing, it is fair to include each in diagram of the circular flow.
e)At equilibrium the leakages from the flow equal the injections:
Where S is saving, T is taxes, M is imports, I is investment, X is exports and G is Government spending.
The output of the economy must equal investment plus consumption to ensure no real resources have been lost.
If saving were greater than investment, incomes and output would fall, contracting the economy. Households would reduce saving to continue their consumption, and their lower income (on which less tax would be paid) could afford fewer imports. The leakages would decrease until equilibrium was regained.
If investment were greater than savings, incomes would rise, resulting more tax revenue, more saving and more spent on imports. The leakages would increase until equilibrium was regained, with a larger economy.
Question 2
a)In a closed economy, the aggregate demand for money (MD) varies inversely with the interest rate. Figure 1 shows that as the total income of the economy (Y) changes the demand for money, the resulting interest rate resulting from the fixed money supply changes as well, with a locus of the equilibria between income and interest rates (the money market) shown in Figure 2. This is the LM curve. Points above the line display excess money supply and the interest rate must fall to reach equilibrium; points below display excess money demand and the rate must increase.
M*
Money Supply
Output/Income
Y1
Y2
r1
r2
Interest Rate
Interest Rate
∆Y
MDY1
MDY2
LM
Figure 1
Figure 2
Figure 2
Income
LM
Aggregate demand for goods and services positively correlates with income. It therefore depends on the interest rate, as this affects the investment in the economy; as the interest rate falls there will be more investment and more income. The IS curve (Figure 3) shows the locus of points of equilibrium in the goods and services market, where the leakages and injections to the circular flow are equal.
Combined, the IS-LM diagram (Figure 4) pinpoints the equilibrium for a closed economy (where international trade cannot affect the money supply) where both the goods and money markets are in equilibrium at Z.
Income, Y
Interest, i
IS
LM
Z
Y*
i*
I
IV
III
II
Figure 4
Quadrants I - IV show disequilibrium:
- I: Excess supply of goods; excess money demand
- II: Excess demand for goods and money
- III: Excess demand for goods; excess money supply
- IV: Excess supply of goods and money
Here the interest rate must change to reach equilibrium.
For example, in quadrant I there is a low interest rate given the money supply. This encourages investment to bring the economy back onto the IS curve.
As it is also below the LM curve, money demand is greater than supply. The interest rate must therefore rise again to decrease this demand and encourage saving, bringing the economy back onto the LM curve, until the economy recaptures equilibrium at Z.
b)An increase in government spending will increase incomes, generating higher aggregate demand for goods and services. This is represented by the IS curve shifting right from IS1 to IS2. The higher income will result in a greater demand for money, but due to the fixed money supply (the static LM curve) a higher interest rate will be required for equilibrium to dampen the money demand. This results in the new equilibrium at point X, with the higher national income Y1 and higher interest rate i1.
c)“Crowding out” occurs when governments borrow money to fund extra expenditure (“deficit spending”), with the result that private investment is driven off by the resulting higher interest rates. Governments raise money by issuing bonds which compete with private debt instruments, resulting in pressure to increase interest rates. This can “crowd out” private investment as the higher price makes it less worthwhile due to the lower rates of return.
The effect can also occur when the government simply cuts taxes, as this also increases the money demand and shifts the IS curve right.
Bibliography
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