ECS1601 EXAM PACK

INTERDEPENDENCE OF THE MAJOR SECTORS, MARKET AND FLOWS IN A MIXED ECONOMY Production is not pursued for its own benefit, the ultimate aim is to use or consume the products to satisfy human wants. Production creates income and this income is then spent to purchase products. Production, Income and Spending The Three major ’Flows’ in the economy 1.Production – Production occurs and thus, generates income 2.Income – Income is earned as a result of production 3.Spending – The income earned is spent to buy the available goods and services Although this version of the circular flow is simple, it teaches us four key insights that remain true (albeit in slightly refined forms) in more sophisticated versions as well. 1. Spending = production. The total value of all spending by households becomes an inflow into the firm sector and thus ends up on the revenue side of a firm’s balance sheet. The revenues received by firms provide us with a measure of the total value of production in an economy. 2. Production = payments to inputs. Flows in and out of the firm sector must balance. The revenues received by firms are ultimately paid out to households. 3. Payments to inputs = income. Firms are legal entities, not people. We may talk in common speech of a firm “making money,” but any income generated by a firm must ultimately end up in the hands of real people—that is, in the household sector of an economy. The total value of the goods produced by firms becomes an outflow of dollars from the firm sector. These dollars end up in the hands of households in the form of income. (This ownership is achieved through many forms, ranging from firms that are owned and operated by individuals to giant corporations whose ownership is determined by stock holdings. Not all households own firms in this way, but in macroeconomics it is sufficient to think about the average household that does own stock in firms.) 4. Income = spending. We complete the circle by looking at the household sector. The dollars that flow into the household sector are the income of that sector. They must equal the dollars that flow out of the household sector—its spending. A Flow and A Stock (Box 3-1 Stocks and Flows) STOCKS FLOWS • Has No Time dimension - can only be measured at a particular/specific point in time • Has a Time dimension – can only be measured over a period of time • Water level of dam measured at a particular point in time (at 00:00 on May 1 2007 capacity was 72,64%) • Flow of water into the dam measured over a period (1 May 2007 inflow was measured as 250 cubic metres per second • Stock taken; Taken counts • Calculation of sales, profit or loss • Still pictures • Moving pictures Examples • Wealth • Assets • Liabilities • Capital • Population • Balance in savings account • Unemployment • Gold reserves held by SARB Examples • Income • Profit • Loss • Investment • Number of births and deaths • Saving • Demand for labour • Gold sales, gold production • Stocks and flows are related • Stocks can only change as a result of flows • Prices are ratios between different flows • Ratios between a stock and flow and visa versa have a time dimension • Ratios between two stocks and two flows have no time dimension The basic sets of markets in the economy 1. Goods Markets – Markets for goods and services owned by the firms 2. Factor Markets – Markets for factors of production owned by the households 3. Financial Markets – Markets for the transaction of financial assets or securities owned by the financial sectors 4. Foreign Exchange Market for the transaction or trading of currencies among nation. Interdependence of Households and Firms HOUSEHOLDS FIRMS All people who live together and who make joint economic decisions or who are subjected to others who make such decisions for them Unit that employs factors of production to produce goods and services that are sold on the goods market • Every individual is a member of a household • The Basic decision-making unit in the economy • Own factors of production • Sell them in the factors market to firms • In exchange they receive income to purchase consumer goods in the goods market • Consume goods and services to satisfy human wants • The Basic productive units in the economy • Firms purchase factors of production in the factor market • Transform factors into goods and services • Sell these goods in the goods market • Members are called consumers – the act of consuming is consumption • Capital purchased by firms – the act of purchasing capital goods is called Investment or Capital formation • Total spending is called total or aggregate consumption • Denoted by the symbol (C) • Denoted by the symbol (I) CIRCULAR FLOW OF GOODS & SERVICES CIRCULAR FLOW OF INCOME AND SPENDING • Households sell their factors of production to firms in the factors market • Firms purchase factors of production in the factors market • Firms transform factors into goods and services • Firms’ spending represents income of the households • Sell the goods and services to households in the goods market • Households spend their income to purchase goods and services in the goods market • A clockwise circular movement • Households’ spending represents income of the firms • An anti-clockwise circular movement 2 3 Circular flow of goods and