Overview
This lecture finalizes the circular flow of income model in macroeconomics, focusing on how government actions influence national income, employment, and aggregate demand.
The Circular Flow of Income Model
- The basic model includes households and firms exchanging money for goods, services, and wages.
- Households can save instead of spending, reducing immediate demand for firms' output.
- Savings are reinvested into firms via financial institutions if the economy is not in recession.
- Households may spend on imported goods, diverting money abroad (imports).
- Foreigners may buy domestic goods and services, bringing money in (exports).
The Role of Government
- Government collects taxes from households and firms, reducing their disposable income.
- Tax revenue is used for spending, which can include direct goods/services provision or subsidizing firms.
- Government spending increases demand for domestic firms’ output, boosting production, employment, and national income.
- Government affects the economy through fiscal policy: changes to taxation and spending.
Effects of Fiscal Policy
- Increased government spending raises demand for domestic goods, leading to higher output and employment.
- Reduced government spending lowers demand, reducing output, employment, and national income.
- Increased taxes reduce households' and firms’ ability to spend, lowering demand and national income.
- Reduced taxes boost disposable income, increasing demand, production, and national income.
Leakages and Injections
- Leakages: Savings, imports, and taxes remove money from the domestic economy, reducing aggregate demand.
- Injections: Investment, exports, and government spending add money, increasing aggregate demand.
- National income rises with increased aggregate demand (injections) and falls with reduced demand (leakages).
Inflation and Borrowing
- Higher demand may lead to price increases across the economy (inflation).
- If government both increases spending and reduces taxes, it must borrow money, increasing national debt.
- Preferably, borrowing should come from abroad to avoid negative effects on domestic lending.
Key Terms & Definitions
- Circular Flow of Income — Model showing the movement of money between households and firms.
- Aggregate Demand — Total demand for domestically produced goods and services at different price levels.
- Disposable Income — Income remaining after taxes; can be spent or saved.
- Fiscal Policy — Government policy on taxation and spending used to influence the economy.
- Leakage — Money exiting the domestic economy through savings, taxes, or imports.
- Injection — Money entering the domestic economy via investment, exports, or government spending.
- National Income (Y) — Total value of goods and services produced; often measured as real GDP.
- Inflation — Sustained increase in the general price level of goods and services.
Action Items / Next Steps
- Draw and label the circular flow of income diagram as covered in the lecture.
- Answer the provided review questions on government influence in the economy.
- Prepare for a future lesson on aggregate demand and supply curves.