In order to
develop a simple short-run model of the economy, we make the following
assumptions:
·
That
technical knowledge and resources are fixed in the short run
·
That
there is a fixed relationship between output and employment
·
There
is no international trade
·
There
is no government sector; ie there are no taxes and no government expenditure
·
Firms
distribute all profit to their owners (households) immediately when it is
earned
·
All
investment is carried out by firms
·
All
prices are constant, so that any change in numeric GNP is caused by a change in
real GNP.
Firms produce all consumption
goods and services, which are purchased by households. Households own all
factors of production (resources) – labor, land, capital goods, etc. – as well
as the firms themselves. This results in a circular flow of income.
The national
output (GNP) is the flow of all final goods and services in an economy within a
given period. The Net National Product (NNP) is GNP less depreciation, or in
other words the level of output above and beyond that which would be required
simply to maintain the existing stock of capital goods. In calculating GNP and
NNP, only final goods and services
are included. Intermediate goods, which is to say goods that are used in the
production of other goods, are not included, because otherwise double-counting
would occur.
GNP can be
calculated in three different ways:
·
By
finding the total expenditure on final goods and services
·
By
finding the value added by each producer
·
By
finding the total income earned by each factor of production
In practice,
it can be quite difficult to make the determination between final and
intermediate goods. The second method may be easier because it only requires
knowing the value of output and the value of factor inputs for each firm in the
economy. The final method is perhaps the easiest, since it is a simple sum of
all household incomes.
Inputs to
production include primary factors and intermediate goods. Intermediate goods
are those factor inputs that were produced in the current period. All other
inputs used in the current period are primary factors. Labor input is a primary
factor, as are (most) buildings and machinery. The income paid to owners of
primary factors must be financed by a firm’s sales and are normally classified
as:
·
Wages
and salaries – paid in exchange for the use of labor services
·
Rent
– paid in return for the use of land and capital goods not owned by the
producer
·
Interest
– paid to the households who have loaned money to purchase land and capital
·
Gross
profits – residual money accruing to the firm after payment has been made to
all other factors, usually distributed in the form of dividends to the
households that own the firm
The sum of
payments by a firm for primary factors and intermediate goods will equal the
firm’s receipts from sales. As a result, the value added by the firm is equal
to the sum of payments to primary factors, because this will equal sales (total
value of production) less payments to intermediate goods (value that came from
somewhere else). Since GNP equals the sum of producers’ value added, GNP is
also equal to the sum of producers’ payments to primary factors of production
(GNP=GNI).
The
equivalency between GNP and GNI depends on the definition of profits as a
residual amount obtained after deducting the value of all other inputs to
production; and on the assumption that all profits are immediately distributed
to households. In the real world, these assumptions may not hold.
Given that
GNP=GNI, it follows that the income received by households must be just
sufficient to purchase all output produced by the economy. It would seem that
by the act of establishing a firm and producing output, sufficient income must
thereby be produced so that the firm’s output can be paid for. While this is
true, it is not guaranteed that this new income will result in effective demand
for the firm’s goods. Some income might not find its way into expenditure at
all, at least in the short run.
The level of
output that can be sustained is therefore dependent on the level of expenditure
or effective demand. Potential output sets the limit to the level of income and
expenditure possible, but actual output may fall short of this limit. The short
run theory of income determination sees acual output as dependent on effective
(aggregate) demand.
Households
engage in two activities, consumption and savings. Consumption (C) consists of
expenditure on goods and services to satisfy current needs or wants. For the
purpose of this simple model, we shall ignore the problems raised by consumer
durables (like cars), which yield a flow of services over time. Savings (S) is
whatever income is left over after C. It follows that gross national income
(GNE aka Y) = C+S.
Firms also engage
in two activities, investment and production. Production occurs to satisfy the
consumption demand of households and is in equilibrium only when it is equal to
that expenditure, so it is also represented by the symbol C. Investment is the
production of goods and services which are not used for consumption purposes.
There are two main categories of investment: Inventory and capital goods.
Buildup of unsold inventory is a form of investment; reduction in inventory is
a form of disinvestment. Some investment in capital goods is required just to
maintain current levels of production, but additional investment over and above
this amount will result in increased productive capacity in the future.
Investment expenditure is given the symbol I. Total output will equal C+I.
Total output is GNP, which is equal to Y, so: Y=C+I.
If Y=C+I and
Y=C+S it follows that I=S. Investment and savings are defined in such a way
that they must be equal. This does not mean that planned saving always equals
planned investment; quite the contrary. However, by the definitions of the
model, actual savings is the amount of money that will be available for acual
investment and thus the two will be equal. If planned investment is lower or
higher than planned savings, firms will find themselves encountering an
unplanned investment or disinvestment.
If all
income were consumed, then all value added (output) would accrue to private
households through factor incomes, and all factor incomes would be used by
households to purchase consumption goods and services from firms. In such an
economy, supply would create its own demand, as all income would be consumed.
There would be no withdrawals or injections to the circular flow of income, so
that any flow of national income would continue in an indefinite equilibrium,
with no tendency for GNP (or GNI or GNE) to change. This of course assumes a
fixed capacity output, but this is a short-run model. In reality, if all income
were to be consumed, the stock of capital goods would decline and output would
be reduced.
In practice,
most economies save and invest a proportion of national income, as shown in the
diagram above. Savings are not passed on in the circular flow of income, but
constitute a withdrawal from it. In other words, savings do not constitute a
component of aggregate demand, because the act of saving does not generate a
demand for current output. Investment, on the other hand, is an injection into
the circular flow of income. It is part of aggregate demand because the act of
investing (buying more capital goods) does indeed generate a demand for current
output.
Any
withdrawal has a contractionary effect on the level of national income. Any
injection has an expansionary effect. Equilibrium can only occur when the
contractionary and expansionary effects are in balance, or in other words when
there is consistency between the savings plans of households and the investment
plans of firms. If planned savings and planned investments are equal, the
economy will be in equilibrium. If they are not equal, the economy will be in
disequilibrium and must expand or contract until the plans again come into
balance. In the equilibrium diagram above, households elect to save 10% their
income. If households change their plans and choose to save twice that amount
(20%) then the economy will be in a contractionary disequilibrium:
Under these conditions, and if there are no changes to the
planss of investors or savers, national income will fall. In the earlier,
equilibrium model, aggregate demand (Y) was equal to $100 billion, equal to C
($90 bln) + I ($10 bln). Now, C has fallen to $80 billion with I unchanged at
$10 billion, resulting in aggregate demand (Y) or $90 billion. The sales
reciepts of firms will have fallen accordingly. As a result, firms will not be
able to sell all the output produced, so there will be an unplanned increase in
inventories. Inventories will continue to increase so long as output is
maintained at the original level. Soon, firms will react by reducing the level
of output. Assuming that firms continue
to plan to invest $10 billion, and households continue to plan to invest 20% of
their income, a new equilibrium will be established:
The result
of Y=$50 billion is a result of the savings plans of households. If firms
output Y by a lesser amount, say to Y=$70 billion, then households will plan to
save $14 billion, which is still higher than the investment plans of firms. A
new equilibrium will not be reached until the savings plans of households again
equal the investment plans of firms. There is a multiplier effect in evidence
here: A change of $10 billion in the savings plans of households has caused a
change of $50 billion in GNP.
The motives
for households to save and for firms to invest are quite different. Households
save so that they can buy expensive goods in the future, or to protect against
becoming unemployed, or to leave wealth for their children, or through sheer
miserliness. Firms invest in the expectation of profits, and the volume of
investment is clearly a function of the availability of profitable investment
opportunities. But even when investment opportunities are poor, households will
still wish to save. Because of these divergent motives, there is no guarantee
that the plans of savers and investors will be consistent, even in the short
run with which this model is concerned. For this reason, the level of national
income realized can and does depart from full employment income.
