The Short-run Macroeconomic Equilibrium

A very simplified Keynesian model is used to show the short-run macroeconomic equilibrium. For example, the rate of interest is fixed to simplify the model by keeping constant money in the economy. It is also assumed that production and employment depend on the amount of spending. In that we mean that if people buy more then firms will produce more, providing that they have the spare capacity available. The basic formula we use is that the level of National Income is equal to the domestic consumption plus the three withdrawals from the circular flow of income. Or, in shortened terms: Y = Cd + W. In this model, aggregate demand is actually known as aggregate expenditure (E) and relies on the amount of domestic consumption and the injections into the circular flow of income (J). Also written as AD = E = Cd + J. We reach a point of equilibrium when withdrawals equal injections and at this same point National Income will equal aggregate expenditure. If injections were to be higher than withdrawals then National Income would rise and the withdrawals would rise until withdrawals is once again equal to injections. Now enter the 45 degree line.

The 45 degree line shows the relationship between National Income and consumption, withdrawals and injections. Consumption and withdrawals are endogenous - their value is determined by the model. However injections are exogenous, meaning their value is determined independently of the model.

At ever point on the 45 degree line (Y), the items on each axis equal each other. The C line is consumption. It differs from Cd because it doesn't contain taxes and export spending. Consumption is a function of National Income: C = f(Y). As National Income rises, so does consumption - hence the upwards slope. It crosses the 45 degree line because poorer people may be required to spending above their earnings to survive where as richer people spend less than they earn, therefore at the end of the line it is below the Y line. The slope is given by the marginal propensity to consume - the proportion of any increase in National Income that goes on consumption. It is the change in consumption divided by the change in National Income. 

Consumption is determined by a whole bunch of different things: 

• Taxes
• Expected future incomes
• Expected future prices
• Consumer confidence
• Household wealth 
• Attitudes of the lenders
• Age of 'durables'
• Distribution of income

Any changes in these cause a shift in the consumption function whereas a change in National Income causes a movement along the consumption function. 

Now onto the withdrawals. The amount saved depends on the marginal propensity to save (mps). The proportion of an increase in National Income that is saved. Mps = Change in savings / Change in N.I. Taxes is pretty much the same - it depends on the marginal propensity to tax (mpt), or changes in tax / changes in N.I. It tends to rise as National Income rises because income tax is progressive. Finally imports - depending on the marginal propensity to import. Or, mpm = change in imports / change in National Income. 

Total withdrawals will look something like this: 

Injections now and we'll start with investment. It is determined by the following things: Consumer demand, expectations, interest rate, availability of finance and cost/efficiency of capital equipment. Replacing new equipment will rely on National Income. Government spending is independent of National Income in the short term, Exports is also classed as independent on National Income to keep the model simpler.  

That's it for the background on the theory. Next we'll be moving on to how National Income is determined from all of this. Stay tuned.

Sam. 

The Circular Flow Of Income

*I'd like to start by wishing everyone a happy new year! I hope you all had a good time over the festive period and are getting back into the swing of things as life returns to normal. I've had a great 4 week break and am now back studying, which mean the blog will be starting again on a consistent basis until Easter!*

Today's focus will be on the circular flow of income. I'm aware this has already been discussed but like I mentioned in a previous post I do plan on going over things again in a little more depth. The best way to learn about the circular flow of income is to actually see the flow graphically:

I'll now break the flow down into it's different sections, starting with the inner flow. The inner flow consists of the factors payments going from the firm to the households and payments for goods (consumption) flowing in the opposite direction. Firms pay money to households in the form of wages, interest and rent in return for the services of these factors of production. On the other side, households pay money to firms when they consume the firms goods and services. Note we're talking only about domestic firms and domestic households here.

In a scenario where all money was spent then that would complete the flow. However, in reality, not all money is spent. This is where the concepts of injections and withdrawals from the flow come in. Withdrawals are exactly what they sound like: money being taken out of the flow. It comes in three main forms. Firstly, savings. When money is deposited in banks or other financial institutions for the future that money has been withdrawn from the flow. Taxation is another withdrawal. Income tax and national insurance comes out of a households income whereas VAT comes out of a households consumption. Receiving benefits from the government is essentially a 'negative tax'. It's a tax that is flowing in the opposite direction. Therefore the total withdrawal in the form of net taxes is total taxation minus benefit payments. The final withdrawal is import spending. This is money that has left the flow of income because it is spent on goods and services abroad.

Injections, defined as additional money flowing into the economy, also comes in three forms. Firstly: investment. Investment is money that firms spend after gaining it through financial institutions. Secondly there is government spending. This includes such things as spending on roads, hospitals, schools and the like. It does not include state benefits, that is important to note! Finally, the other injection is export spending. Money that has come from people abroad buying our domestic goods and services.

There is a slight relationship between the withdrawals and injections into the circular flow of income. For example, suppose more money is saved (withdrawal) then more money will be available for banks to lend out to firms for investment (injection). The higher taxation is (withdrawal), the more like the government are to increase spending (injection). However, we must remember that these choices are made by different people. The choice to save and the choice to invest are made by two completely different, independent parties and therefore each will have their own agenda. Due to this we can say that injections may not equal withdrawals, however they could.

The final point I'd like to discuss here is equilibrium in the circular flow if income. Like most things in economics, market forces are able to bring the circular flow to equilibrium. I'll give an example. Suppose that injections exceed withdrawals. This may be because investment has rise, but irrespective of the reason due to  this national income will rise (because of more money circulating). A higher national income means that people can consume more, but as well as this people can also save more, pay more taxes and buy more imports. Therefore withdrawals will rise, and continue to rise up to a point where it is equal to injections. This is when equilibrium has been reached and national income will remain constant until another change occurs.

Thank you for reading guys and girls. Contact me if you have any questions or feedback, have a good day/night! Sam.