MACROECONOMICS AND

THE CIRCULAR FLOW

Dr Fikret AUEVI
School of Economics and Business,
University of Sarajevo
- Principles of Economics Sarajevo, 1 December 2016

MACROECONOMICS AND THE BIG ISSUES

OF MACROECONOMICS

Macroeconomics is the study of the economy as a system.

Macroeconomics stresses broad aggregates such as the total

demand for goods and services by households (households
consumption), the total spending on machinery and builidings by
firms (private investment), the total spending on goods and
services by the government (government consumption), or the
exchange of goods and services with foreign countries.

Full attention of macroeconomics is on the big picture of the whole

economy (an economy as a system).

THE BIG ISSUES OF MACROECONOMICS

Examples of the big issues are:

Real gross national product

Economic growth

Labor force and unemployment

Inflation and inflation rate

NATIONAL INCOME ACCOUNTING

GROSS DOMESTIC PRODUCT (GDP) measures the output made in the

domestic economy, regardless of who owns the production inputs.

In the circular flow transactions do not take place exclusively between

a single firm and a single household.

Firms hire labor services from households but buy raw materials and
machinery from OTHER FIRMS.

To avoid double counting we use VALUE ADDED.

VALUE ADDED is the increase in the value of goods as a result of the

production process.

NATIONAL INCOME ACCOUNTING

When calculate GDP we EXCLUDE intermediate goods to avoid double counting.

INTERMEDIATE GOODS are partly finished goods that form inputs to a

subsequent production process that then uses them up.

That is WHY intermediate goods are EXCLUDED from GDP calculation.

When we calculate GDP we ONLY SUM UP the total value of FINAL GOODS
purchased during the year and the difference between INVENTORIES at the end
of a year and at the beginning of the year.

FINAL GOODS are purchased by the ultimate user, either households buying
consumer goods or firms buying capital goods such as machinery.

INVENTORIES or STOCKS are goods currently held by a firm for future

production or sale.

THE CIRCULAR FLOW

The CIRCULAR FLOW shows how real resources and

financial payments flow between FIRMS and HOUSEHOLDS
(inital level of analysis in a closed economy).

The EXTENDED CIRCULAR FLOW shows how real resources

and financial payments flow between FIRMS, HOUSEHOLDS,
GOVERNMENT and FOREIGN SECTOR (international trade).

THE CIRCULAR FLOW BASIC MODEL

HOUSEHOLDS supply factor services to firms that use these inputs to make
output (products or services).

FACTOR SERVICES are: labor, natural resources, physicial capital, and savings.

Households EARN factor incomes (wages, rent, interest and profits).

Households SPEND their incomes buying the output of firms.

Buying the output of firms households give firms the money to pay for
production inputs.

THE CIRCULAR FLOW HOUSEHOLDS AND FIRMS

Payments for goods

and services

Payments for goods

and services
Flow of goods
and services

MARKET FOR GOODS

AND SERVICES

FIRMS

Flow of goods
and services

HOUSEHOLDS

Factors of production

Factors of production

FACTOR MARKETS
Payments for factors
of production

Payments for factors

of production

THE CIRCULAR FLOW EXTENDED MODEL

EXTENDED CIRCULAR FLOW includes the role of investment and

savings in the economy, the role of government spending, and the role of
trade in goods and services with foreign countries (international trade).

INVESTMENT (I) is the purchase of new capital goods by firms.

SAVING (S) is part of income NOT SPENT buying goods and services.

A LEAKAGE (an outflow of money) from the circular flow is money no

longer recycled from households to firms.

An INJECTION (an inflow of money) into the circular flow is money that
flows to firms without being cycled through households.

MACROECONOMIC EQUILBRIUM BETWEEN

AGGREGATE SUPPLY AND AGGREGATE DEMAND

Product

Machinery for furniture

Sales to

Sales to

Market value

firms

households

(mil EUR)

(mil EUR)

(mil EUR)

1.200

1.200

2.000

2.000

Production
Machinery for auto
Industry
Total value of sales to firms
Furniture
Clothes
Cars
Total value of sales

3.200
1.600
1.000
3.500

1.600
1.000
3.500

to households
Total value of unsold

6.100
0

production
Inventories (stocks) of
Unsold production working
capital investments

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THE CIRCULAR FLOW WITH

SAVING AND INVESTMENT
Payments for goods
and services

Payments for goods

and services

Flow of goods
and services

MARKET FOR GOODS

AND SERVICES

Flow of goods
and services

Investments an injection

FIRMS

Savings a leakage
Credit

FINANCIAL MARKET
(Commercial banks)

Factors of production

HOUSEHOLDS

Factors of production

FACTOR MARKETS
Factor incomes

Factor incomes

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INVESTMENT AND SAVING

The total value of investment is equal to the value of

the machinery procured.

Investment, consequently, appears as an injection of

additional purchasing power onto the market for goods,

...

in contrast to savings as a leakage of purchasing

power from the markets for goods and services.
The funds invested are equal to savings overall.

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MACROECONOMIC IDENTITIES
IN A CLOSED ECONOMY

GDP = C + I
Y=C+S
GDP = Y
C+I=C+S
Follows:

I=S

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MACROECONOMIC DISEQUILBRIUM BETWEEN

AGGREGATE SUPPLY AND AGGREGATE DEMAND

Product

Machinery for furniture

Sales to

Sales to

Market value

firms

households

(mil EUR)

(mil EUR)

(mil EUR)

1.200

1.200

2.000

2.000

Production
Machinery for auto
Industry
Total value of sales to firms
Furniture
Clothes
Cars
Total value of sales

3.200
1.600
1.000
3.500

1.300
800
3.000

to households
Total value of unsold

5.100
0

(1.000)

production
Inventories (stocks) of
Unsold production working capital
investments

1.000

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THE ROLE OF STOCKS IN

THE NATIONAL INCOME ACCOUNTING

In this new situation, which is in reality much more common than conditions of
ideal equilibrium are, the companies have produced 1 billion more in
output than households have actually purchased.

In economic analysis and the system of national accounts, this accounting

quantity is referred to as investment in current assets or changes in
stocks. This means that the macroeconomic equation (equilibrium), previously
given as:
GDP = C + I,

holds good, with the following addendum:

Investment (I) comprises the following two segments:
investment in fixed assets (IFA), and
changes in stocks (investment in current assets or Stocks),
So that

I = IFA +/- Stocks.

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THE ROLE OF STOCKS IN

THE NATIONAL INCOME ACCOUNTING

During a given business year the business sector

may sell less product than it has produced during the

year. In that case the sign in front of Stocks will be
positive (+), to signify an increase in stocks.

We record an increase in stocks as investment in

capital goods (investment in current assets),

while a reduction in stocks in a given year is treated as

disinvestment (a reduction of investment in current
assets).

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THE ROLE OF GOVERNMENT

IN THE CIRCULAR FLOW

GOVERNMENTS collect revenue through DIRECT TAXES - Td (income taxes, profit

taxes) and INDIRECT TAXES - Ti (VAT, excises).

TAXES finance two kinds of expenditure.

GOVERNMENT SPENDING on goods and services (G) is purchases by the

government of physical goods and services.

Governments also spend money on TRANSFER PAYMENTS or BENEFITS (B).

BENEFITS include pensions, unemployment benefit, pensions for war veterans and
civil victims of the war (in BiH). Transfer payments are payments that do not require
the provision of any goods or services in return.

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THE CIRCULAR FLOW WITH

THE ROLE OF GOVERNMENT
Payments for
goods and services

Payments for
goods and services
Flow of goods
and services

MARKET FOR GOODS

AND SERVICES

Flow of goods
and services
Governments purchases

Investments

Taxes (net)

GOVERNMENT
(fiscal policy)
FIRMS

Public debt - bonds

Loans

FINANCIAL MARKET
(commercial banks)

Factors of production

Savings

HOUSEHOLDS

Factors of production

FACTOR MARKETS
Factor incomes

Factor incomes

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GROSS DOMESTIC PRODUCT AT BASIC PRICES

AND DISPOSABLE INCOME
Y = GDP at basic prices = (C + I + G) Ti
DI = Y + B - Td
DI disposable income of all households in an economy
Y - gross domestic product at basic prices (GDP Ti)
B - transfer payments from budget
Td direct taxes

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MACROECONOMIC IDENTITIES IN A CLOSED

ECONOMY WITH SAVINGS AND TAXES

S = DI C = (Y+B -Td) - C
Y = S + C + Td - B
Y = C + I + G Ti

and from

Y = S + C + Td B ,

it follows:

Y = C + I + G Ti = S + C + Td B
I + G Ti = S + Td - B
I + G = S + Td + Ti - B

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THE ROLE OF FOREIGN SECTOR

IN THE CIRCULAR FLOW

The foreign sector plays an important role in an OPEN ECONOMY or

economy that deals with other countries.

EXPORTS (EX) are domestically produced but sold abroad (in

foreign countries).

IMPORTS (IM) are produced abroad but purchased for use in the
domestic economy.

DIFFERENCE between EXPORTS and IMPORTS is trade balance or

NET EXPORT.
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Exports
(injection)

Payments for goods

and services

Payments for goods

and services

Goods and services

INTERNATIONAL
MARKETS

MARKET FOR GOODS

AND SERVICES

Imports

Goods and services

Government purchases
of goods and services
Taxes

Investments

(leakege)

GOVERNMENT
(fiscal policy)
FIRMS

Public debt
Loans

FINANCIAL MARKET
(commercial banks)

Factors of production

Savings

HOUSEHOLDS

Factors of production

FACTOR MARKETS
Factor incomes

Factor incomes

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LEAKAGES FROM AND INJECTIONS

TO THE CIRCULAR FLOW
LEAKAGES from the extended circular flow are:

SAVING (S)
TAXES (net of benefit subsidies) (NT)
IMPORTS (IM)

INJECTIONS to the circular flow are:

INVESTMENT (I)
GOVERNMENT SPENDING (G)
EXPORTS (EX)
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MACROECONOMIC IDENTITIES
IN AN OPEN ECONOMY
GDP = C + I + G + (EX IM)
EX exports;

IM - imports

EX IM = NX (net export)
GDP = C + I + G + NX
Using GDP at basic prices we get:
Y = C + I + G + EX IM Ti = C + I + G + NX Ti
C + I + G + EX = C + S + T + IM

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RELATIONS BETWEEN
LEAKAGES AND INJECTIONS
SUM OF ALL LEAKAGES from an economy is EQUAL to the
SUM OF ALL INJECTIONS to the economy this is a law in
macroeconomics.

S + NT + IM = I + G + EX
If a countrys INVESTMENTS exceed its SAVINGS then the
country is a net foreign debtor that is reflected in the fact
that IMPORTS are higher than EXPORTS for the same amount.

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GROSS DOMESTIC PRODUCT:

THE EXPENDITURE APPROACH
According to the expenditure approach GDP is the sum of following
expenditures:
1. Expenditures of households on PERSONAL CONSUMPTION (C) goods
(including durable goods) and services;
2. GROSS PRIVATE INVESTMENT (I) expenditures on newly built apartments
and houses, newly produced equipment and machinery, newly constructed
buildings, plus the difference in INVENTORIES at the end and at the beginning
of the year;
3. GOVERNMENT EXPENDITURES on goods and services (G);
4. NET EXPORTS (exports minus imports of goods and services- NE).

G D P = C + I + G +/- NE
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GROSS DOMESTIC PRODUCT:

THE INCOME APPROACH
According to the income approach GDP is the sum of following
incomes and costs:
1. Wages and salaries of employees
2. Net interest earned
3. Rents
4. Indirect taxes, corrections and statistical discrepances
5. Depreciation
6. Income from self-employment
7. Corporate profits before taxes (dividends + retained profits +
corporate income taxes)

GDP = 1 + 2 + 3 + 4 + 5 + 6 + 7
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GROSS NATIONAL PRODUCT (GNP) AND

GROSS DOMESTIC PRODUCT (GDP)

GROSS NATIONAL PRODUCT measures total income earned by

domestic citizens regardless of the country in which their factor
services were supplied.

GNP equals GDP plus NET PROPERTY INCOME FROM ABROAD.

In developed countries GNP is usually greater than GDP.

In developing countries GDP is usually greater than GNP.

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GROSS NATIONAL PRODUCT

Gross national product (GNP):

1.
2.
3.
4.
5.

Consumption of households (C)

Gross private investments (I)
Government expenditures on goods and services (G)
Net exports (NE)
Net property income from abroad (NPI)

GNP = C + I + G + NE + NPI

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FROM GROSS NATIONAL PRODUCT

TO NATIONAL INCOME
GROSS NATIONAL PRODUCT
minus Depreciation
= NET NATIONAL PRODUCT
minus Indirect taxes
= NATIONAL INCOME (the sum of rental income, profits, income
from self-employment, and wages and salaries)

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DEPRECIATION

DEPRECIATION or capital consumption is the rate at which the

value of the existing capital stock declines per period as a
result of usage or obsolescence.

Rates of depreciation are set up by the law or bylaws in

countries all over the world.

Enterprises are obliged to use these rates when calculating

costs and preparing PROFIT AND LOSS ACCOUNTS.

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NOMINAL AND REAL GNP

NOMINAL GNP measures GNP at the prices prevailing when income

was earned (at current market prices).

REAL GNP or GNP at constant prices, adjusts for inflation by

measuring GNP in different years at the prices prevailing at some
particular date known as the base year.

The GNP deflator is the ratio of nominal GNP to real GNP expressed
as an index.

PER CAPITA REAL GNP is real GNP divided by the total population. It
is real GNP per HEAD.
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