Session 9

            National income determination I
            Circular flow of income. Investments, government  
            spending and exports. Saving, taxation, imports.
            The concept of equilibrium level of national       
            income.
            The concept of aggregate demand - consumption,     
            investment and government expenditure.

            Use circular flow analysis to explain the concept  
            of the equilibrium level of the national income.

One classical model to study the behaviour of a national economy
is the circular flow of income, which includes the goods and
services market, the labour market, and the money market.

The flow, in this model goes from individuals to firms, and from
firms to individuals.

Individuals supply firms with labour and capital. Firms supply
individuals with the payment to those factors: wages, rent, interest
and profits.

Thus, the main assumption in this model is that the goods and
services provided by firms using labour and capital supply by
individuals are all sold to the individuals, which buy the
goods and services with the wages, rent, interest and profits.
The cycle, in the next round of the circular flow of income will
reach a higher level if the amount of capital provided is larger
than in the previous cycle.

Of course, this model will need some complications to mimic the
behaviour of a real economy. The model needs to introduce an agent
for social organization (social order, legal order, defense from
external threats), which will be a Government. Also, the model
needs to introduce international trade, exports and imports that is.

Therefore, this circular flow of income model will consider, first,
what happen to wages, rent, interest and profits when they reach
the pockets of individuals:

a) individuals will have to pay taxes
b) some individuals will save part of their income
c) some individuals will buy foreign goods and services, they will
   import.

If we think of wages + rent + interest + profit as the total value
added created in a national economy during one year, then we have
that this TOTAL NATIONAL INCOME equals TOTAL NATIONAL OUTPUT.

Therefore, after individuals pay taxes, save money and import goods
and services, the remaining INCOME will be less than the value
of TOTAL NATIONAL OUTPUT. The economy will be in trouble because
stocks of unsold goods and services will accumulate.

If we call the aggregate TAXES + SAVING + IMPORTS as LEAKAGES, we will
have
  TOTAL NATIONAL INCOME - LEAKAGES < TOTAL NATIONAL OUTPUT

But, in real life economies, governments will finance their 
expenditure with taxation, firms will invest with money borrowed
from savings, and some of the goods and services domestically
produced will be sold to foreigners (exports).

If we call the aggregate 
    GOVERNMENT EXPENDITURE + INVESTMENT + EXPORTS as INJECTIONS, we
can state that

TOTAL NATIONAL INCOME - LEAKAGES will be equal to
TOTAL NATIONAL OUTPUT  only if
          LEAKAGES equals INJECTIONS, because INJECTIONS - LEAKAGES = 0
          if that is the case.

Then, if LEAKAGES = INJECTIONS the economy will be in a state of
equilibrium. This is the notion of national equilibrium, or, in
economic theory, the notion of KEYNESIAN EQUILIBRIUM.

This situation can be expressed as follows:

Taxes + savings + imports = Gov. expend. + investments + exports

The above contains the BUDGET  ( taxes - Gov. expenditure)
                        TRADE  ( exports - imports )
                 MONEY MARKET  ( savings - investments )

The relationship between budget, trade, and money market, in a
situation of national equilibrium will be as follows:
 
        BUDGET = (investments - savings) + (exports - imports)

        TRADE  = (savings - investments) + (taxes - Gov. expend.)

  MONEY MARKET = (Gov. expend. - taxes) + (exports - imports)

As one can see, from the model is clear that a complex combination
of budget surplus/deficit, money market balance/unbalanced, and
trade surplus/deficit can produce different conditions of

NATIONAL EQUILIBRIUM....the ONLY condition is that
      taxes + savings + imports = Gov. exp. + investment + exports

The above is the environment for economic planning using two
tools the government can utilize:
                        fiscal policy  (taxes, tariffs, subsidies,
                                        expenditure on goods and
                                        services)
                    and monetary policy ( interest rates - and
                                          exchange rates )

One very important feature of NATIONAL/KEYNESIAN EQUILIBRIUM is
that it can occur at any level of output, and, consequently, at any
level of employment. Thus, if the government wanted to push the
economy to higher levels of employment, it can use monetary policy
and fiscal policy to push national demand for goods and services
to a higher level. This is the concept of "managing demand",
associated to Keynesian approaches to the national economy.

Of course, in order to manage demand, it is necessary to build a
sound definition of aggregate demand. It can be constructed grouping
the following economic acts:

1) consumption by individuals of goods and services both domestically
   and externally produced. These goods and services are consumption
   goods and services.

2) consumption by the government of goods and services both domestically
   and externally produced. These goods and services are consumption
   goods and services.

3) investment by firms and government on goods and services utilized
   to produce other goods and services. The former are capital goods.

4) consumption by foreigners of domestically produced goods and
   services, both consumption and capital goods. EXPORTS.

5) to measure the aggregate demand for domestically produced capital
   and consumption goods and services we have to substract imports
   of externally produced capital and consumption goods and services.

Now, the adding up of 1) + 2) + 3) + 4) + 5) will give us a model
of aggregate demand for or aggregate consumption of domestically
produced goods and services. If we label 1) as C, and 2) as G, and
3) as I, and 4) as X, and 5) as M, we have

aggregate demand (AD) = C + G + I + (X-M)

With the above model in mind, a government can manipulate different
components of aggregate demand to stimulate or slowdown the growth
of the national economy.

Examples: can change direct and indirect personal taxation to
          produce variations in C. Can legislate levels of
          wages (minimum wages, etc), to produce variations in C.

          can use government economic policies to increase/decrease
          government expenditure via increase/decrease welfare state,
          increase/decrease investments in public goods (health,
          education, housing, etc)

          can utilize subsidies/taxation to increase/decrease the
          amount of private investment. Can change levels of
          interest rate to increase/decrease credit with the
          purpose of increase/decrease levels of investment and/or
          levels of consumption.

          can increase/decrease interest rate to trigger off
          changes in the exchange rate to increase exports/decrease
          imports.
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