Transcript two-sector, two-market circular flow

TWO-SECTOR, TWO-MARKET CIRCULAR FLOW:
 A simple circular flow model of the macro economy containing
two sectors (business and household) and two markets (product
and factor) that illustrate the continuous movement of the
payments for goods and services between producers and
consumers. The payment flow between the two sectors and two
markets is conveniently divided into four segments representing
consumption expenditures, gross domestic product, factor
payments, and national income.
 The two-sector, two-market circular flow model is the simplest
way to show the inherent interrelationship between producers and
consumers in the macro economy.
 Two Sectors, Two Markets
 The two macroeconomic sectors included in this model are:


Household Sector: This includes everyone, all people,
seeking to satisfy unlimited wants and needs. This sector is
responsible for consumption expenditures. It also owns all
productive resources.
Business Sector: This includes the institutions (especially
proprietorships, partnerships, and corporations) that
undertake the task of combining resources to produce goods
and services. This sector does the production. It also buys
capital goods with investment expenditures.
 The two macroeconomic markets in this basic version
of the circular flow are:
Product markets: This is the combination of all markets
in the economy that exchange final goods and services.
It is the mechanism that exchanges gross domestic
product. The full name is aggregate product markets,
which is also shortened to the aggregate market.


Resource markets: This is the combination of all
markets that exchange the services of the economy's
resources, or factors of production--including, labor,
capital, land, and entrepreneurship. Another name for
this is factor markets.
 The Basic Circular Flow
Consumption
National Income
GDP
Factor Payments
 Circulating Around
 This diagram presents the simple two-sector, two-market
circular flow. At the far left is the household sector
containing people seeking consumption. At the far right
is the business sector that does the production. At the top
is the product markets that exchange final goods and
services. At the bottom is the resource markets that
exchanges the services of the scarce resources.
 •Gross Domestic Product: Consider first the upper righthand segment of the circular flow between the product
markets and the business sector. This is the revenue
received by the business sector for the production of
goods and services, what is officially termed gross
domestic product (GDP).


Factor Payments: Moving clockwise with the flow, the lower
right hand segment between the business sector and the factor
markets is factor payments. These are payments to the owners of
labor, capital, land, and entrepreneurship for the productive
services they provide. Factor payments can be divided into
specific items depending on the resources involved, including
wages, interest, rent, and profit.
National Income: Continuing clockwise to the lower left hand
segment between the factor markets and the household sector is
national income. Definitional speaking this is the income earned
by the factors of production, which are owned by the household
sector.
 Consumption Expenditures: The last segment of this flow,
between the household sector and the product markets in the
upper left hand corner, is consumption expenditures.
 Illustration 1
 The fundamental equations in a two sector economy are
given as: Consumption C = 300 + 0.8Y and the
investment function I = 400.
1. Derive the saving function
2. Find the equilibrium level of productivity the equating
the saving leakages to the investment injections
 Solution
 (1)
 The saving function is given by

S
=
Y–C

S
=
Y – (300 + 0.8Y)

S
=
– 300 + 1Y – 0.8Y

S
=
– 300 + 0.2Y
 Hence, the saving function is given by S =
- 300 + 0.2Y
 (2)
 The equilibrium level of productivity can be determined by
equating the saving leakages to the investment injections.
 Thus,
- 300 + 0.2Y =
400

- 300 – 400
=
- 0.2Y

- 700
=
- 0.2Y
 Or
0.2Y
=
700
 Thus, the equilibrium level of productivity is 3,500
 Illustration 2
 For a two sector economy we have the following
equation for consumption function
 C = 120 + 0.75Y, determine the following
1. If investment in a year is $70 million what will be the
equilibrium level of income or productivity
2. If full employment level of income is $920 million
what investment is required to be undertaken to ensure
equilibrium at full employment
 Solution
 (1)

We know Y
=
C+I

Y
=
120 + 0.75Y + 70

Y – 0.75Y
=
120 + 70

0.25Y
=
190
=
190 / 0.25

Y
 Thus, if the investment in a year is $70 million, then
the equilibrium level of income or Productivity (Y)
will be $760 million.
 (2)
 To ensure full employment equilibrium investment should
be equal to the saving gap at full employment income. With
the given full employment income equal to $920 million,

S=Y–C

S = 920 – 120 – 0.75 (920)

S = 800 – 0.75 (920)

S = 800 – 690
 Thus, investment required for full employment
equilibrium is $110 millions
 Illustration 3
 If in a two sector economy Consumption C = 900 +
0.8Y and Investment I = 1,080 then
1. Determine the equilibrium level of income and
consumption
2. Derive the saving function and determine the saving at
the equilibrium level
3. Determine the equilibrium level of income by equating
planned investment
 Solution
 (1)
 The equilibrium condition is given as Y = C + I
 Thus,
Y
=
900 + 0.8Y + 1,080

Y
=
1,980 + 0.8Y

Y – 0.8Y
=
1,980

0.2Y
=
1,980

Y
=
1,980 / 0.2

 Thus, the equilibrium level of income (Y) is 9,900
 The consumption function C = 900 + 0.8Y
 When Y = 9,900
C
=
900 + 0.8(9,900)
C
=
900 + 7,920
 Thus, the equilibrium level of
consumption C is 8,820
 (2) The saving function is given by S = Y – C

S
=
Y – (900 + 0.8Y)

S
=
Y – 0.8Y – 900

S
=
0.2Y – 900
 Thus the saving function is given by S = 0.2Y – 900
 At equilibrium level,
S
=
0.2 (9,900) – 900

S
=
1980 – 900
 The saving function at Equilibrium will be S = 1080
 The planned saving is given by S
= - 900 + 0.2Y
 (3)In equilibrium, planned saving equals planned
investment
S = 0.2Y – 900
 Thus,
1080=0.2Y – 900


0.2Y - 900 =
1080

0.2Y =
1080 + 900

0.2Y =
1980

Y
1980 / 0.2
=
 Thus, the equilibrium level of income (Y) is 9,900