Flashcards in L2 - The Circular Flow of Income - from Quesnay to Kenyes Deck (17):
What occurs in a Barter Economy?
- Because there is no money
- we assume "value equivalents" are exchanged; goods going from person 1 to person 2 are worth exactly the same as those going in the opposite
Why are Barter Economies inefficient?
- Barter is only an efficient form of exchange when there are very few individuals and goods.
- When there are billions of goods and individuals barter is simply impossible, as it involves the need to find buyers for what you have to sell who simultaneously have what you wish to buy the so-called “double coincidence of wants” --> Someone wants what your selling and you want what they are selling
- Therefore some form of money – as a medium of exchange and store of values --> vital to enable the many trillions of transactions that take place every day. The role of money is therefore fundamental to macroeconomics
What are exchanges like with money?
- between two people there is the transfer of goods as well as money now instead of just good like in a barter system
- Even though the flow of Goods and Money are in opposing direction they are equivalent in value - so one can be eliminated
Why are the Goods (or commodity lines eliminated in an Exchange of Money system?
The goods (or commodity) flows are eliminated for 2 reasons:
1- it is only possible to add the values of groups of different commodities if they are expressed in money terms
2- Many transactions take place only in monetary form (e.g. tax payments) --> may get paid later on e.g. NHS
Why do we use Aggregation in the National Economy?
The national economy is more complicated because there are many millions of goods and millions of people and so aggregates are used: aggregates of goods (all valued in terms of money) and aggregates of people. Empirical values can be assigned to these aggregates and ordered into a circular flow of income
What is a Circular Flow?
A circular flow is a closed system; i.e. for every aggregate of individuals the sum of outgoing flows must equal the sum of the incoming flows. In other words there are no leakages or injections within the circular flow
The circular flow is:
- a theory which yields classifications by way of various aggregates
- it embodies empirical investigations of the economy as a whole
What was Quesnay's model on the Circular Flow?
Quesnay (1694-1774), divided (French) society into three social classes: landlords, artisans and farmers
- Landlords: receive all their income from rent and spend it on food (purchased from farmers) and luxury goods (purchased from the artisans)
- Artisans (sterile class): receive income from the sale of manufactured products to farmers and landlords and spend it on food (from farmers) and raw materials. Their net surplus from these transactions is assumed to be zero.
- Farmers (productive class): receive income from landlords and artisans from sales of food; and use it to pay rent to landlords, and for seed corn and subsistence for the next year
What is the interpretation of Quesnay's model of Circular Flow?
The agricultural surplus is always the same – the model is of a “stationary state” –there is no economic growth and so each year is exactly the same as the previous one (as surplus was used to get seeds for the next year).
- This is a reflection of the importance of agriculture in French society in the 18th century- where it was believed that only nature (i.e. land) was able to produce value
-Any tax on the agricultural sector will reduce the surplus and hence lower national social wealth.
- An increase in consumption by landlords will reduce the agricultural surplus (as rents will have to rise) and this will lead to lower national social wealth.
- The only way to raise net social wealth is through increasing the productivity of the agricultural sector
Why wasn't Quesnay's Circular Flow Model used by British Classical Economics?
Quesnay’s circular flow model wasn’t much used by the succeeding British Classical economists (except for Karl Marx). There are 2 reasons for this:
- The Classics had a much broader definition of productive workers – including artisans and industrial workers (although not landlords) rather than just farmers
-It took a static view of the economy(forever constant level of income) and not a dynamic view essential for economic growth which occurs over time and which was the main interest of the Classical economists, such as Smith, Ricardo and Marx
- The circular flow of income, however, is fundamental to modern macroeconomics
What does a Basic Modern Circular Flow look like?
The modern economy is assumed to consist of households and firms
Firms produce goods and services and sell them to households; households consume goods and services and sell labour (and other factor) services to the firms.
What is the differences/ similarity between the Basic Modern Circular Flow and Quesnay's?
- The economy is partitioned functionally and not socially (by class). A person belongs to a household when consuming but to a firm when producing
It is assumed that all market transactions result in added value not just agriculture
- In the simple Modern Circular Flow as firms produce only consumption goods and households spend all their income then owing to the axiom of a closed flow:
- total factor income = total consumption expenditure
- Like Quesnay’s model there is no investment and this is a stationary model of the economy
How can Savings and Investment be added to the Basic Circular Flow?
A more realistic model would be to acknowledge that households do not spend all of their income but save some; and firms do not all produce consumption goods but also capital goods. The model now looks like:
- The Households buys goods and services from Firms, and they provide factor services to firms and savings to Capital Formation
- Capital formation receive Savings from households and firms, while providing Gross Investment to Firms
- Firms provide goods to households and savings to Capital formations while receiving Factor Services from Households and Gross investment from Capital Formation's
How can Output be represented as a function of Savings and Investment?
-The system is still a closed flow if savings (S) are ex post (actual returns that have been measured) equal to gross investment (I). i.e. if withdrawals (S) by households are exactly equal to injections (I) by firms
- More specifically: Household income (Y) is made up of consumption (C) plus savings (S) - [Y = C + S]
Firms’ output (Y) consist of consumption goods (C) and capital (investment) goods (I) – [Y = C + I ]
- So therefore: S = I if the economy consists of only firms and households
How can the the Circular Flow Y=C+I be extended?
- a government Sector
- The rest of the world
How does the Government fit into the Circular Flow of Income?
- Households --> the government now receives tax payments and pays Factor & transfer incomes
- Capital Formation --> the government receives Gross Investment and pays savings
- Firms --> the government receives tax payments and pays Subsidies & government purchases
What are the Key feature of the Circular flow of income with the Government included?
- The dashed lines are those from the previous chart and the solid lines are the new flows appertaining to the government sector and so the circular flow of income remains a “closed” flow
- The government raises taxes from households and firms, which it spends on the output of firms, subsidies to firms, transfer payments (pensions etc) and factor incomes (wages) to households
- The government may also ‘save’ some tax revenue it receives to contribute to gross investment (e.g. hospitals, schools and infrastructure)