Macroeconomic Basics - Circular Flow of Income (CFoI)

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• Consumption (C) is spending on goods and services for final use (consumption) during this period.
• Investment  (I) - an injection into the CFoI - is the purchase of actual physical capital (equipment etc.), or the improvement of peoples skills and expertise - final spending on things which are intended to increase income levels in future periods rather than this one. [Please Note:  Firms are responsible for most of this investment, not governments, though some government spending is investment for future periods rather than spending on current (this year's) goods and services]
• Saving (S) is just and only income which is NOT spent on final goods and services. (= Yd - C) - a withdrawal from the CFoI. [Please Note:  Investment spending is matched with Savings through the financial and money markets (see below), which are separate from this Circular Flow of INCOME picture of the economy]
• Government Spending (G) is ONLY spending on final goods and services (wages and salaries, paper, power, building maintenance and improvement etc.) used up in this period or intended for use in future periods (includes any government investment) - an injection into the CFoI
• The other (major) part of total government expenditure is Transfer Payments:  social security, unemployment benefit, public (national) pension payments etc.  which simply add directly to the recipients incomes, and which are not paid in return for actual services.
• Taxes are the government reciepts - actually also raised on the spending loop (VAT, excise duties), as well as on income streams (income and corporation taxes)  - T is best thought of as total taxes minus transfer payments - a withdrawal from the CFoI
• Exports of goods and services provide income for firms, and also measure this part of total output of the economy - an injection into the CFoI
• Imports of goods and services leak income out of the national (domestic) flow of income - a withdrawal from the CFoI
• Total Expenditure equals Output (C + I + G + X - IM) equals Income (called Gross Domestic Product) (Y) which equals Disposable Income (Yd) plus Taxes.

Distinguish between

• trend growth (improvement in technology and productivity (outputs per unit inputs)) typically about 2.5 - 3.5% per year
• cyclical growth (or decline) round the trend growth - booms (strongly positive growth rates) and recessions (slower growth rates) or depressions (negative growth rates).

• Increasing Injections (G, I, X) and/or reductions in Withdrawals (T, S, IM) will increase the CFoI (increasing income and output (expenditures) and vice versa.
• Multiplier process - increasing an injection (for instance) increases income, which then leads to further increases in spending and resulting income
• until income levels have risen sufficiently that new levels of withdrawals equal the new level of injections (increasing incomes tend to lead to increased savings, taxes and imports).  Y (GDP) will not be in equilibrium until resulting Withdrawals balance Injections

• Government Fiscal Policy (the balance between G and T) can influence equilibrium Income levels
• Increase G (or reduce T) to counteract  a recession
• Reduce G (or increase T) to counteract an unsustainable boom (income growth exceeding full capacity of the economy, which leads to inflation - see below)

• Total Capacity of the economy to generate output and income depends on the quantities of land, labour, management and capital plant and equipment available
• When all of these factors of production are fully employed, the economy is operating at full capacity.  Otherwise, there is unemployment - the economy could produce more income and output.
• Capacity can be increased by:
• investment in capital plant and equipment - more capital for production and output;
• increase in the labour force participating in the economy - more employment -> more output & income;
• improvement in technology - more output & income from the same amounts of labour and capital through technological improvement - better quality and more productive capital;
• improved productivity of labour - better skilled and better organised labour increasing the amounts that can be produced and the income that can be earned;
• structural change- re-organisation of resources among different firms with lower costs, improving management.
• Fiscal Policy (G and T) can affect these capacity increasing processes - so should be used with care and caution.

• National Income (GDP) = P x Y  (a grand sum of millions of price times quantity trades) - where Y is real income - in terms of purchasing power over all goods and services, and P is the general price level (an index of all prices in the economy)
• Money (M) is the medium through which these trades take place (notes, coins, and current accounts with banks)
• Money is a STOCK which is exchanged between different people and businesses as trades happen
• The FLOW of money round the CFoI is given by M x V, where V is the Velocity of Circulation - the number of times any one £ changes hands in the course of 1 year.
• MV = PY (the Quantity equation of exchange) always holds - it is the only way of defining and measuring V.
• If V is constant, then PY (nominal or current GDP, national income) can only increase if M increases.
• If Y is fixed by the Capacity Constraint - at Yf (full employment national income), then any increase in MV will lead to an increase in P - inflation.