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H E P R E V I O U S C H A P T E R took a long-term perspective on growth of GDP. Sources of output growth were broken down into growth of labor inputs, increases in capital per worker, and improvements in technology and organiza- tion. Discussions of changes in GDP in the short run typically take a different perspective. For example, in January 2009 the government reported that U.S. real GDP fell at a 3.8 per- cent annual rate in the fourth quarter of 2008, the sharpest drop since 1982. News reports said nothing about growth of population, capital, or total factor productivity. Instead, they focused on the behavior of individual components of GDP. Consumption expenditures,
CHAPTER 8
The Circular
Flow of Income
and Expenditure
1. How households and firms are linked by incomes and expenditures
2. How expenditure is divided into consumption, investment, government
purchases, and net exports
3. The relationships between injections and leakages in the circular flow
4. Why some investment is planned and other is unplanned
5. How the concept of equilibrium can be applied to the circular flow of income
and expenditure
6. What the multiplier effect is and how it is related to the business cycle
1. Gross domestic product (GDP)
2. Opportunity cost
3. Equilibrium
4. Inventories
5. Real and nominal values
6. The business cycle
After reading this chapter, you will understand the following:
Before reading this chapter, make sure you know the meaning of the concepts:
232 CHAPTER 8 d The Circular Flow of Income and Expenditure
especially for durable goods like cars, led the decline in total GDP. Exports, also, decreased as U.S. trading partners also slipped into recession. Federal government purchases rose moderately, counter to the trend of other GDP components, but the rise was partially offset by weakness of spending by state and local governments. The data on investment received special attention. Overall, investment was down; but one category, increases in inventory, was up. While inventory invest- ment helped moderate the total drop in GDP for the fourth quarter, it was taken as a bad sign for the future. At this point in the business cycle, the increase in business inventories did not reflect an optimistic stocking up by businesses to meet growing consumer demand. Instead, it was an unplanned buildup resulting from disappoint- ing sales. Business firms were expected to cut back their orders for goods in the new year until the unwanted inventory buildup was worked off. This chapter will adopt the same focus on GDP components as that used in news reports. It begins by introducing the circular flow of income and product , dividing the economy into five major sectors, and showing important linkages among them. In the second part of the chapter, the circular flow is used to develop the important con- cept of planned expenditure, which serves as a first step in building a general theory of macroeconomics.
The Circular Flow
Figure 8.1 divides the economy into five main sectors: firms, households, government, financial markets, and the rest of the world. Arrows indicate flows of payments among the sectors. We can begin with the largest and most important set of flows, those rep- resenting the incomes that households receive from business firms and the expendi- tures they make in purchasing goods and services from those same firms.
Gross Domestic Product, Domestic Income, and Consumption
At the top of Figure 8.1 we encounter gross domestic product (GDP), a measure of a country’s total output of goods and services. The production of goods and services by business firms generates income for the country’s households.^1 The bulk of this income consists of wages and salaries. Some is also paid out in interest, rents, and royalties on capital and natural resources owned by households and loaned or sold to firms. What- ever firms have left over, after they have paid all wages and other costs of production, is profit. Profit is earned by the firm’s owners, who are a subset of households.^2 The sum of income received in the form of wages, rents, interest, and profit by all households is known as gross domestic income , or for short, simply domestic income. From the way the circular flow is drawn, it is clear that domestic income and domestic product must be equal, since payments equal to the value of what is produced and sold are paid out to households—either as elements of costs (wages, interest, rents) or as profit (what is left over when cost is subtracted from the value of output).^3 In Figure 8.1, which shows the simplest imaginable economy, households immedi- ately spend all the income they receive to purchase goods and services from the firms that
Circular flow of income and product
The flow of goods and services between households and firms, balanced by the flow of payments made in exchange for goods and services
Gross domestic product (GDP)
The value at current market prices of all final goods and services produced annually in a given country
Gross domestic income (domestic income)
The total income of all types, including wages, rents, interest payments, and profits, paid in return for factors of production used in producing domestic product
234 CHAPTER 8 d The Circular Flow of Income and Expenditure
The second leakage shown in Figure 8.2 is saving. Saving is the part of domestic income that is not used by households to purchase consumer goods or pay taxes. This economic definition of saving differs a little from the everyday idea of saving as money placed in a bank account or mutual fund. Saving, in the economic sense, also includes repayment of debt and spending that builds equity in a home. Also, corporations sometimes retain part of their profit for reinvestment in their operations. Looked at from the point of view of the circular flow, we can consider the retained earnings to be
FIGURE 8.2 LEAKAGES AND INJECTIONS IN A SIMPLE CLOSED ECONOMY
Households do not spend all of their income on consumption. Part of it "leaks out" of the basic circular flow of income and consumption through payments of taxes and through saving. These two leakages are balanced by "injections" of expenditure into the basic circular flow in the form of government purchases and investment. Total leakages (S + T) must equal total injections (I + G) for this simple closed economy.
Tax revenue
The total value of all taxes collected by government
first “earned” by the households who own the firm and then “saved” by those house- holds in the sense that they, as shareholders, approve the idea of using the retained profits for reinvestment. To match the leakages, Figure 8.2 also shows two injections. Injections are types of expenditure on goods and services that have any origin other than the household consumption that was shown as part of the basic circular flow in Figure 8.1. The first injection is government purchases of goods and services or, more sim- ply, government purchases. These include all purchases of goods made by all levels of government (national, regional and local) plus services purchased from contractors and the wages paid to all government employees. Government purchases do not include transfer payments like social security, disability payments, or unemployment compensa- tion. As explained earlier, those items, which are not payments for currently performed services, are subtracted from tax revenue to get the leakage “net taxes.” The sum of gov- ernment purchases of goods and services plus transfer payments is called government expenditures or, sometimes, government outlays. The second injection is investment. Investment, as the term is understood in macroeconomics, is made up of two components. The first, fixed investment , means purchases of newly produced capital goods—machinery, office equipment, software, farm equipment, construction of buildings used for business purposes, including construction of rental housing, and so on. The second component, inventory investment , means changes in stocks of finished goods ready for sale, stocks of raw materials, and stocks of partially completed goods in process of production. Inventory investment has a negative value if stocks of goods decrease in a given period. The term investment as used in macroeconomic models is sometimes called eco- nomic investment to emphasize that it means expenditures on real productive assets and inventories. Economic investment should not be confused with financial investment , which means purchases of corporate stocks, bonds, and other securities. The latter are
Saving
The part of household income that is not used to buy goods and services or to pay taxes
Injections
The government purchase, investment, and net export components of the circular flow
The Circular Flow of Income and Expenditure d CHAPTER 8 235
Farm equipment is a large part of farming fixed investments.
Transfer payments
Payments by government to individuals not made in return for services currently performed, for example, unemployment compensation and pensions
The Circular Flow of Income and Expenditure d CHAPTER 8 237
kets that can help keep interest rates low and stimulate private investment. This link between the government budget and private investment does not mean that it is always a mistake for the government to run a deficit. Circumstances when it can pru- dently do so will be discussed in detail in Chapter 11. However, we can see even from the simple circular flow that the way the government’s budget is managed has impor- tant implications for the health of the economy as a whole.
The Open Economy
We do not live in a closed economy. Our economy has many links, both real and financial, with the rest of the world. By adding these links, Figure 8.3 represents the circular flow model for an open economy. The first link that is added to the circular flow for an open economy is another leakage, imports. In everyday life, we are used to thinking of imports as goods flow- ing into the economy, so it might seem surprising to see imports represented as a leakage, not an injection. However, there is a simple explanation. Remember, the circular low represents flows of money, not flows of physical objects. The leakage represented by the “imports” arrow could perhaps more accurately be labeled “pay- ments for imports of goods and services.” Then it would be more clearly seen as what it is: The part of household income that is devoted to purchase of goods and services produced in the rest of the world, rather than in the domestic economy.^5 Figure 8.3 also adds a new injection, exports , to match the import leakage. Again, we could more fully describe this item as “payments from the rest of the world for goods and services exported from the domestic economy.” It would then be apparent why an arrow representing an injection of funds into the domestic economy represents “exports”. The final detail added to Figure 8.3 is a pair of arrows linking the rest of the world to domestic financial markets. Just as government purchases do not always exactly equal net taxes, resulting in a government surplus or deficit, imports do not always exactly equal imports, resulting in a surplus or deficit of payments with the rest of the world. In the context of the circular flow, we call this external surplus or deficit net exports , which means exports of goods and services minus imports. In everyday discussions, the term net exports is instead called the trade surplus (or the trade deficit if imports exceed exports).^6 If imports exceed exports, where do domestic purchases get the funds they need to buy all the imports? Only part of the imports can be financed by funds received from exports. The balance must come in the form of financial inflows from the rest of the world, shown in the diagram by an arrow from the rest of the world to domestic financial markets. The most common forms of financial inflows are borrowing from foreign banks or other lenders, and sales of domestic securities like stocks or bonds to foreign investors. Financial inflows are also often called capital inflows. On the other hand, if exports exceed imports, the opposite question arises: How do foreign buyers afford the exports, since only part of them can be paid for by the payments they receive through the “imports” arrow of the circular flow? The answer is that an export surplus must be financed by financial outflows. The most common forms of finan- cial outflows are lending by domestic banks and other financial institutions to foreign bor- rowers, and purchases of foreign securities like stocks or bonds by domestic investors.
Open economy
An economy that is linked to the outside world by imports, exports, and financial transactions
Financial inflow
Purchases of domestic assets by foreign buyers and borrowing from foreign lenders; also often called capital inflows
Financial outflow
Purchases of foreign assets by domestic residents or loans by domestic lenders to foreign borrowers— also often called capital outflows
Imports
A leakage from the circular flow consis- ting of payments made for goods and services purchased from the rest of the world
Exports
An injection into the circular flow that consists of payments received for goods and services sold to the rest of the world
Net exports
Payments received for exports minus payments made for imports
238 CHAPTER 8 d The Circular Flow of Income and Expenditure
Gross Domestic Product = Gross Domestic Income
Firms Households
Consumption
Government
Financial markets
Net taxes
Saving
Leakages
Investment
Borrowing
Debt repayment
Exports Rest of the World Imports
Financialinflows Financialoutflows
Injections
Imports
purchases
Government
FIGURE 8.3 CIRCULAR FLOW IN AN OPEN ECONOMY
This version of the circular flow represents an open economy that is linked to the rest of the world through imports (a leakage) and exports (an injection). If imports exceed exports, the excess imports must be financed by a financial inflow from the rest of the world. If exports exceed imports, the resulting trade surplus will be balanced by a financial outflow. As was the case in a closed economy, total injections must equal total leakages (S + T + Im = I + G + Ex).
240 CHAPTER 8 d The Circular Flow of Income and Expenditure
Over the past 20 years, the government budget and trade deficits of the United States have inspired a great amount of comment and controversy. To understand the many issues raised by these “twin deficits,” it is helpful to interpret them in terms of the equality of leakages and injections. The needed data are shown in the chart. The upper part of the chart is based on a classification of leakages and injections into three components corre- sponding to a rearrangement of the terms of the leak- ages-injection equation in the form (Ex − Im) + (G – T) + (I − S) = 0. G − T represents the consoli- dated federal, state, and local budget deficit, stated as a positive number when government purchases exceed net taxes. Ex − Im is the trade surplus (net exports), which becomes a nega- tive number when there is a trade deficit. The I − S component is positive if domestic investment exceeds domes- tic saving and negative if there is more domestic saving than investment. The lower part of the chart shows saving and investment separately. Looking at the chart, we see that the trade deficit grew steadily, from less than 1 percent of GDP in 1991 to over 6 percent of GDP by 2005. As we know from our discussion of the circu- lar flow, a trade deficit must be matched by a financial inflow from the rest of the world. This financial inflow can be used either to finance the government budget deficit, to finance extra private investment beyond what can be financed by domestic saving, or some of both. Looking at the chart, we see three periods representing different relationships among the various leakages and injections. In the early 1990s, there was more domestic saving than investment. The extra saving was enough to finance both
domestic investment and part of the government budget deficit so that the needed financial inflow from the rest of the world, and the associated trade deficit, were small. During the later 1990s, the government budget swung into surplus. Other things being equal, this could have allowed the United States to finance all of its own investment—and the trade balance could have moved into surplus; but this did not happen. Instead, as the lower part of the chart shows, just at this time the U.S. economy experienced an investment boom, especially in information technology. Simultaneously, private sav- ing fell. The government surplus helped to finance the investment boom but was unable to do so in full, so financial inflows from abroad were still needed. At the end of the 1990s, the high- tech investment boom collapsed; and the economy fell into recession. With incomes falling and transfer payments for unemployment com- pensation rising, the government budget swung back into deficit. The administration of President George W. Bush decided to use tax cuts to stimulate spending in order to speed recovery from the recession. Perhaps in part because of the tax cuts, the recession did prove to be a short one, but the eco- nomic recovery did not restore the government budget to surplus. Instead, the continued effect of tax cuts, spending to finance the war in Iraq, and other factors pushed the government budget far into deficit. At the same time, investment was rising again—this time with an emphasis on housing rather than information tech- nology. Where was the country to find the funds to finance all of this? Not from domestic saving. Although business saving in the form of retained corporate profits grew strongly, household saving fell to record lows. Total saving thus grew only weakly, not enough even to finance domestic investment let alone the growing budget deficit. That meant that financial inflows from abroad had to finance both the budget deficit and large part of the housing boom. At the end of 2007, the housing bubble burst; and the U.S. economy moved into a severe recession. Investment fell, closing the gap between investment and domestic saving, but the government budget deficit increased to a record high. By 2008, the economy found itself in the clas- sic “twin deficit” situation in which the government was wholly dependent on financial inflows from the rest of the world to finance its borrowing.
SOURCE: Data from The Economic Report of the President, 2 009. Table B-32. Net government investment included in G
- T. Statistical discrepancy included in X – M.
Applying Economic Ideas 8.
UNDERSTANDING THE TWIN DEFICITS
0%
2%
4%
6%
8% Leakages and Injectionsas percent of GDP I-S
G-T
Ex-IM
1990 1995 2000 2005
0%
2%
4% 6%
8%
10%
1990 1995 2000 2005
Net Private Investment and Saving as percent of GDP
Investment Saving
The bursting of the housing bubble sent the economy into a severe recession
The Components of GDP
Our starting point is the circular flow of income and product shown in Figure 8.3. This time our focus is on the total flow of expenditures on goods and services produced by the economy’s business firms. These expenditures consist of consumption (by far the largest component) plus purchases of goods and services by government, purchases of investment goods, and expenditures on exported goods and services. Together, these equal gross domestic product, which in turn, equals gross domestic income. In moving from the circular flow diagram to our macroeconomic model, however, we need to be careful about one detail. The consumption arrow in the diagram repre- sents consumption expenditures on domestically produced goods. A separate arrow rep- resenting the “imports” leakage shows consumption of imported goods. In practice, as we will see in the next chapter, government statisticians do not measure consumption in this way. Instead, the number that they give us in the official national income accounts includes consumption of both domestic and imported consumer goods. The same applies to purchases of imported investment goods by business firms and imported goods used by government. Without adjustment, then, the sum of consumption, invest- ment, government purchases, and exports would overstate expenditures on domestically produced goods and services and, hence, would overstate domestic GDP. The needed adjustment is, fortunately, very simple. To get an accurate measure of GDP, we simply need to subtract total imports from total measured expenditures. That gives us the following key equation from which we begin construction of our model, in which Q stands for the total quantity of output, that is, GDP, and the final component, Ex - IM, represents net exports:
Q = C + I + G + (Ex − Im)
Planned Versus Unplanned Expenditure
Earlier in the chapter, we pointed out that investment could be broken down into f ixed investment and inventory investment. Our next step is to divide inventory investment, in turn, into planned and unplanned components. Inventory investment is considered planned if the level of inventories is increased (or reduced) on purpose as part of a firm’s business plan. For example, a retail store might increase inventories in response to growth in the number of customers it serves or the number of branch stores it con- structs. Inventory investment is considered unplanned if goods accumulate contrary to a firm’s business plan. This happens whenever demand is less than expected so that some goods the firm bought or produced with the intention to sell them, in fact, remain unsold. If demand is greater than expected, so that inventories unexpectedly decrease (or increase at a rate less than scheduled in the business plan), there is nega- tive unplanned inventory investment (disinvestment). All fixed investment is treated as planned. Total planned investment , then, means fixed investment plus planned inventory investment. All other types of expenditure— consumption, government purchases, and net exports—are also considered to be planned. For that reason, we use the term planned expenditure to mean the sum of
The Circular Flow of Income and Expenditure d CHAPTER 8 241
Planned inventory investment
Changes in the level of inventory, made on purpose, as part of a firm’s business plan
Unplanned inventory investment
Changes in the level of inventory arising from a difference between planned and actual sales
Planned investment
The sum of fixed investment and planned inventory investment
Planned expenditure
The sum of consumption, government purchases, net exports, and planned investment
Who Said It? Who Did It? 8.
JOHN MAYNARD KEYNES: THE GENERAL THEORY
- Changes in net taxes (either taxes paid or transfer payments received), which act by changing the amount of disposable income associated with a given total income
- Changes in consumer wealth, that is, the accumulated value of assets a person owns, is considered apart from current income—One very important example concerns the value of housing, since a home is the biggest asset for many households. In a period when housing prices rise more rapidly than income, as happened in the United States in the early 2000s, consumer spending rises more in proportion to income than it otherwise would.
- Interest rates—If interest rates fall, people can borrow more cheaply and may buy more goods and services on credit. Also, the amount they have to pay in interest on credit cards, mortgages, and other debt decreases, leaving more to buy consumer goods.
The Circular Flow of Income and Expenditure d CHAPTER 8 243
John Maynard Keynes was born into econom- ics. His father, John Neville Keynes, was a lecturer in economics and logic at Cam- bridge University. John Maynard Keynes began his own studies at Cam- bridge in mathematics and philosophy. How- ever, his abilities so impressed Alfred Mar- shall that the distin- guished teacher urged him to concentrate on economics. In 1908, after Keynes had fin- ished his studies and done a brief stint in the civil serv- ice, Marshall offered him a lectureship in economics at Cambridge; Keynes accepted. Keynes is best remembered for his 1936 work, The Gen- eral Theory of Employment, Interest, and Money, a book that many still see as the foundation of what is today called macroeconomics. Although this was by no means Keynes’s first major work, it was the basis for his reputation as the outstanding economist of his generation. Its major features are a bold theory based on broad macroeco- nomic aggregates and a strong argument for activist and interventionist policies. Keynes was interested in more than economics. He was an honored member not only of Britain’s academic
upper class but also of the nation’s highest financial, polit- ical, diplomatic, administrative, and even artistic circles. He had close ties to the colorful “Bloomsbury set” of Lon- don’s literary world. He was a friend of Virginia Woolf, E. M. Forster, and Lytton Strachey; and in 1925 he married ballerina Lydia Lopokovia. He was a dazzling success at whatever he turned his hand to, from mountain climbing to financial speculation. As a speculator, he made a huge fortune for himself; and as bursar of Kings College, he built an endowment of 30,000 pounds into one of over 380,000 pounds. In The General Theory, Keynes wrote: The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. … There are not many who are influenced by new theories after they are 25 or 30 years of age, so that the ideas which civil servants and politicians and even agi- tators apply to current events are not likely to be the newest. Was Keynes issuing a warning here? Whether or not he had any such thing in mind, his words are ironic because he himself has become one of those economists whose ideas remain influential long after they were first articulated.
John Manynard Keynes
244 CHAPTER 8 d The Circular Flow of Income and Expenditure
- Consumer confidence—In periods when consumers feel secure about their jobs and expect their incomes to rise in line with general prosperity, they tend to spend more for any given level of income. In times of pessimism and inse- curity, people tend to be cautious and increase their saving as protection against the expected rainy day.
Planned Investment
The second component of planned expenditure is planned investment. It depends on two principal factors. First, planned investment depends on interest rates (more specifically, on real interest rates, that is, interest rates adjusted for inflation, as explained in Chapter 7). The relationship between interest rates and investment is easiest to understand in the case of a business that needs to borrow in order to invest. Suppose you run a construction business, and you are thinking about improving the productivity of your workers by buying a new backhoe, which costs $50,000. Your banker is will- ing to lend you the money, but you will have to pay 6 percent per year interest, equivalent to $250 per month on the loan of $50,000. If the bank charged 12 per- cent interest, your monthly interest payments would rise to $500; and you would be less likely to buy the new machine. If the interest rate was just 3 percent, monthly interest payments would be only $125; and you would be more likely to make the investment. Although it is not so obvious, interest rates also play a role in investment deci- sions for a company that plans to finance investment from its own retained profits. Suppose that as a result of good profits in the previous year, your construction company had put aside $100,000 in cash. You would not then have to borrow from the bank to buy the backhoe. However, using half of your cash reserves to buy the backhoe still has an opportunity cost that depends on interest rates. For example, if the rate of interest on government bonds is 6 percent, your company could earn $250 per month by using $50,000 of your cash reserves to buy bonds instead of buying the backhoe.^8 That is an opportunity cost. If the interest rate were 12 per- cent per year, your monthly income from the bonds would be $500—a greater opportunity cost—and you would be more tempted to buy the bonds instead of the backhoe. Interest rates influence investment decisions by consumers as well as business. Residential construction accounts for about a third of all private fixed investment in the United States. When mortgage interest rates are low, as they were in the early 2000s, housing construction booms. The importance of interest rates for investment spending is one of the reasons that we will spend several chapters in this book talking about banking, financial markets, and related topics. Interest rates are not the only factor influencing investment decisions. The psy- chological factor of business confidence is also important. By this, we mean the whole complex of expectations and hopes on which firms make their plans for the future. If
Equilibrium in the Circular Flow In Chapter 2, we introduced the concept of market equilibrium. The market for any single good, say chicken, is said to be in equilibrium when the amount buyers plan to purchase equals the amount that producers supply for sale. When the market for chicken is in equilibrium, there will be no tendency for accumulation or decrease of inventories and no immediate pressure for market participants to change their plans. The idea of equilibrium as a situation in which there is no unplanned change in inventories can be extended to the circular flow of income and expenditure. When total planned expenditures (consumption plus planned investment plus government purchases plus net exports) equal GDP, total planned purchases will equal total pro- duction; and there will be no unplanned inventory change for the economy as a whole. As a result, there will be no pressure from unplanned inventory change to cause changes in production plans. If something happens to increase or decrease total planned expenditures, the equilibrium will be disrupted. Let’s see how this process works out as the economy expands and contracts over the business cycle.
An Expansion of Planned Expenditure
Suppose that the circular flow is initially in equilibrium with total planned expenditure exactly equal to GDP. Since goods are being produced at just the rate they are being sold, the level of inventories remains constant from one month to the next. Now sup- pose that something happens to disturb this equilibrium. For example, suppose that development of new energy-efficient technologies causes an upturn in investment as firms replace obsolete, energy-wasting equipment. As equipment makers increase their output of goods to satisfy the increased investment demand, they will take on more workers. The wage component of national income will increase. Profits of equipment makers are also likely to increase, further adding to the expansion of national income. From our earlier discussion, we know that when incomes rise, households will increase their consumption expenditure. So far there has been no change in the output of consumer goods; so as consumption expenditure begins to increase, the first effect will be an unplanned decrease in inventories. Only then, when makers of consumer goods see inventories falling, will they modify their production plans to meet the new demand. As they do so, they too will need to hire new workers; and incomes will rise further. In this way, the original economic stimulus, which began in the industrial equipment sector, spreads through the economy. GDP and domestic income continue to rise, but not without limit. According to the principle of the marginal propensity to consume, peo- ple spend only a part of any increase in income on consumer goods, and each round of the cycle of more-production-more-income-more-spending is smaller than the previous one. Before long, GDP reaches a new equilibrium where production and planned expenditure balance, and there are no further unplanned changes in inventories. Recall that the whole process began with an assumed increase in planned investment. By the time the new equilibrium is reached, the total change in GDP will be greater than
246 CHAPTER 8 d The Circular Flow of Income and Expenditure
the original increase in planned investment because it will also include production of additional consumer goods. The principle that a given initial change in planned expendi- ture changes equilibrium GDP by a greater amount is known as the multiplier effect. The appendix to this chapter explains the multiplier effect in more detail.
A Contraction of Planned Expenditure
The same process operates in reverse if equilibrium is disturbed by a decrease in some category of planned expenditure. For example, suppose a crisis in the Mexican econ- omy reduces U.S. exports to that country. The first effect will be that U.S. makers of export goods will find inventories rising because Mexican importers are not buying as much as they had planned before the crisis. To bring inventories in line with reduced sales, U.S. makers of export goods cut their output. Workers are laid off or work shorter hours, and their incomes fall. As a result, they cut back on consumption expenditures, following the principle of the marginal propensity to consume. When this happens, makers of consumer goods also find that their inventories unexpectedly increase. They, too, cut back on output, and incomes of their workers fall. As this process continues, GDP and domestic income decrease. They do not decrease without limit, however. Before long a new equilibrium is reached. In the new equilibrium, real GDP will have decreased by a greater amount than the original change in exports. This is an example of the multiplier effect operating in reverse.
The Multiplier Effect and the Business Cycle The multiplier effect was one of the key ideas in Keynes’ General Theory. Coming at the height of the Great Depression, the multiplier effect was immediately seized upon as an explanation for the business cycle. Reduced to its simplest form, the Keynesian explanation of the Great Depression went something like this. During the 1920s, the U.S. economy entered a boom due to the multiplier effect of huge investment expenditures, especially expansion of automo- bile production and road building. Then, in 1929, came the Black Friday stock market crash. The crash destroyed business confidence, and investment fell. This time the multiplier effect operated in reverse to produce the Great Depression. At the same time the multiplier effect seemed to give an explanation of the causes of the Great Depression, it also seemed to suggest a cure. What if the gov- ernment increased its purchases of goods and services by enough to offset the drop in private investment? Wouldn’t this send equilibrium GDP back to its original level? This reasoning gave rise to various attempts to spend the country back to prosperity, for example, by hiring thousands of unemployed workers for service in national parks. The nation did not fully recover from the Great Depression until the start of World War II brought on a further surge in government purchases. Modern macroeconomics makes a place for the multiplier effect and recognizes that there is an element of truth in the simple Keynesian view of the business cycle. However, the simple multiplier theory is seriously incomplete. One shortcoming con- cerns changes in the price level over the business cycle. When producers respond to
The Circular Flow of Income and Expenditure d CHAPTER 8 247
Multiplier effect
The tendency of a given exogenous change in planned expenditure to increase equilibrium GDP by a greater amount
The Circular Flow of Income and Expenditure d CHAPTER 8 249
The multiplier effect helps explain how rela- tively small disturbances in expenditure can cause relatively larger changes in GDP over the course of the business cycle.
Key Terms
Gross domestic product (GDP) 252 Gross domestic income (domestic income) 252 Circular flow of income and product 252 Tax revenue 253 Transfer payments 253 Consumption 253 Closed economy 253 Leakages 253 Net taxes 253 Saving 254 Investment 255 Fixed investment 255 Inventory investment 255 Government purchases of goods and services (government purchases) 255 Government expenditures (government outlays) 255 Injections 255 Net exports 257 Imports 257 Exports 257 Financial outflow 257 Financial inflow 257 Open economy 257 Planned investment 261 Planned expenditure 261 Planned inventory investment 261 Unplanned inventory investment 261 Marginal propensity to consume 262 Disposable income 262 Exogenous 265 Endogenous 265 Multiplier effect 267
Problems and Topics for Discussion
- Your personal expenditures What was your income last month (or last year) from all current resources, including wages and salaries plus any interest earned or other investment income? Do not count money that you received as transfer payments, such as government benefits, gifts from family, scholarship grants, and so on. How much was your saving? Did you add to your sav- ings or draw down on past savings? How much did you spend on consumer goods or services? Of your spending, approximately how much do you think was spent on imported goods or services purchased while on foreign travel? Identify where the answer to each of these questions appears in the circular flow diagram, Figure 8.3.
- Planned versus unplanned inventory changes. Suppose your school bookstore manager learns from the admissions office that enrollment of stu- dents will rise by 10 percent next year. What planned inventory investments would the book- store manager make? Suppose that a storm delays the departure of 100 students from another uni- versity who have visited your campus for a hockey game. While waiting for their buses to leave, they decide to browse your school bookstore and buy some items that catch their eye. How would this affect the store’s inventories?
- Injections and leakages in the Russian econ- omy In recent years, Russia has benefited from high world prices for the large amount of oil it produces for export. As a result, Russia has had positive net exports. Because oil is partly state owned and heavily taxed where privately owned, government tax revenues have increased so that the Russian government budget is in surplus. How would these differences between the Russ- ian and U.S. economies affect the direction of the arrows in the circular flow diagram of Figure 8.3? Explain any changes that would need to be made.
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250 CHAPTER 8 d The Circular Flow of Income and Expenditure
- Unplanned inventory change and disequilib- rium Suppose that you read in the news that inventories in retail stores fell last month, to the surprise of analysts. Would you interpret this as a sign of equilibrium or disequilibrium in the cir- cular flow? Which do you think would be more likely in the coming months, an increase or a decrease in GDP? Why?
- Adjustment to change in planned expendi- ture. Starting from a state of equilibrium, trace the effects of each of the following. What hap- pens to inventories? How do firms react? What happens to incomes? To consumption expendi- ture? To GDP? a. Business managers, anticipating future profit opportunities in consumer electronics, in- crease orders for production equipment in order to prepare for the expected increase in demand. b. The federal government reduces income tax rates. c. Good harvests in Africa reduce the demand for exports of U.S. farm products.
Case for Discussion
Excerpts from the Annual Report of the President’s Council of Economic Advisers, 2007
The expansion of the U.S economy continued for the fifth consecutive year in 2006. Economic growth was strong, with real gross domestic product (GDP) grow- ing at 3.4 percent during the four quarters of 2006. Consumer spending sustained its strong growth during the four quarters of 2006 (rising 3.7 percent in real terms), continuing its 15-year pattern of rising faster than disposable income. As a result, the personal saving rate fell to a negative 1.0 percent for the year as a whole—its lowest annual level during the post-World War II era. Corporate net saving rose to 3.8 percent of
gross domestic income (GDI) during the first three quarters of 2006, its highest level since the 1960s. During 2006, real business investment in equip- ment and software grew 5 percent, slower than the 7 percent average pace during the 3 previous years. Its fastest-growing components included computers, as well as machinery in the agricultural and service sec- tors. Investment in mining and oil field machinery was also strong, likely in response to elevated crude oil prices and to the need to replace Gulf of Mexico facilities damaged by the 2005 hurricanes. Inventory investment was fairly steady during 2006 and had only a minor influence on quarter-to- quarter fluctuations. Real nonfarm inventories grew at an average $44 billion annual pace during 2006, a 3.0 percent rate of growth that is roughly in line with the pace of real GDP growth over the same period Real Federal purchases of goods and services grew 2.4 percent during 2006. This was the third consecutive year of growth at roughly 2 percent. Defense spending accounted for all of the increase during the four-quarter period, while non-defense purchases fell. Nominal Federal revenues grew 15 percent in FY 2005 and 12 percent in FY 2006. These rapid growth rates exceeded growth in outlays and GDP as a whole; and the U.S. fiscal deficit, as a share of GDP, shrank from 3.6 percent in FY 2004 to 2.6 percent in FY 2005 to 1.9 percent in FY 2006. The current account deficit (the excess of imports and income flows to foreigners over exports and foreign income of Americans) jumped to 7.0 per- cent of GDP in the fourth quarter of 2005, partly due to petroleum imports that replaced lost Gulf of Mexico production. The current account deficit then retraced some of its earlier increase in the first three quarters of 2006, when oil imports declined.
QUESTIONS
- Why is growth of consumer spending considered a positive factor for expansion of GDP, even when personal saving is falling to a negative level? Are the long-term and short-term effects
