L2 - Circular Flow of Income: From Quesnay to Keynes

Question 1

What is a key feature of all economies?

Answer 1

Exchange`

Question 2

Why is value equivalents only useful in a barter economy?

Answer 2

In proper economy, barter simply impossible. In barter economy, double coincidence of wants needed

Some money needed as a medium of exchange, store of value, standard of deferred payment, unit of account as its vital to an economy

Question 3

In a proper economy what replaces the goods flow of a barter economy and why?

Answer 3

The goods flows eliminated and replaced with money.

Replaced for 2 reasons:

1) Only possible to add the values of groups of dif commodities if expressed in money terms
2) Many transactions take places in monetary form (tax payments)

Question 4

What is a Circular Flow?

Answer 4

Its a closed system
(For every aggregate of individual the sum of outgoing flows must equal sum of incoming flows)

1. A theory which yields classifications by way of various aggregates
2. It embodies empirical investigations of the economy as a whole

Question 5

What is Quesnay’s (1664-1774) model?

Answer 5

-Divided 3 social classes; Landlords, Artisans, Farmers

and explained how the three groups interact.

Question 6

In Quesnay’s model what was unique about the three groups?

Answer 6

• Landlords: receive all their income from rent and spend it on food (purchased from farmers) and luxury goods (purchased from the artisans)
• Artisans (sterile class NOT CONTRIBUTE TO GROWTH): receive income from the sale of manufactured products to farmers and landlords and spend it on food (from farmers) and raw materials. Their net surplus from these transactions is assumed to be zero.
• Farmers (productive class ONLY CLASS IN SURPLUS): receive income from landlords and artisans from sales of food; and use it to pay rent to landlords, and for seed corn and subsistence for the next year

Graph explaining it on notes

Question 7

What is the Interpretation of Quesnay’s model?

Answer 7

• Agricultural surplus always the same hence the model being a ‘stationary state’
• No economic growth (so each year same as the last)
• Reflects importance of agriculture in French Society (18th century) where believed only nature able to produce value
• Any tax on the agricultural sector reduce surplus and hence lower national social wealth
• Increase in consumption by landlords reduce agricultural surplus (as rents have to rise) and this will lead to lower national social wealth

Only way to raise net social wealth is through increasing the productivity of the agricultural sector.

Question 8

What is the Classical Economic Development of the Quesnay Model?

Answer 8

• They had a broader definition of productive workers including: Artisan’s and Industrialists
• They took a dynamic view of economic growth over time compared to Quesnay’s static view

Question 9

What does the Modern Circular Flow look like?

Answer 9

• Not of social classes but functional groups: Households/Firms
• Firms (Goods/Services), Households (Sell Labour)

Question 10

What’s the difference between the Modern Flow and Quesnay’s model?

Answer 10

• The economy is partitioned functionally and not socially (by class). A person belongs to a household when consuming but to a firm when producing
• It is assumed that all market transactions result in added value not just agriculture
• In the simple model above as firms produce only consumption goods and households spend all their income then owing to the axiom of a closed flow:

total factor income = total consumption expenditure

Question 11

What’s the similarities between Quesnay’s model and the modern Model?

Answer 11

• Like Quesnay’s model there is no investment and this is a stationary model of the economy

Question 12

What’s the more realistic model take into account?

Answer 12

Takes into account savings and investment. Firm’s don’t produce all consumption good but also some capital goods

Question 13

What does a Savings and Investment Model look like?

Answer 13

The system is still a closed flow if savings (S) are EX POST(measured) equal to gross investment (I). i.e. if withdrawals (S) by households are exactly equal to injections (I) by firms.

More specifically: Household income (Y) is made up of consumption (C) plus savings (S) - [Y = C + S]
Firms’ output (Y) consist of consumption goods (C) and capital (investment) goods (I) – [Y = C + I ]
So therefore: S = I if the economy consists of only firms and households

Question 14

What does a Circular Flow with a Government Sector look like?

Answer 14

Government
-Buy goods and services from firms and households which they pay for by levying taxes on firms and households

• The government raises taxes from households and firms, which it spends on the output of firms, subsidies to firms, transfer payments (pensions etc) and factor incomes (wages) to households
• The government may also ‘save’ some tax revenue it receives to contribute to gross investment (e.g. hospitals, schools and infrastructure)

Question 15

What happens if you include International Transactions to the Circular Flow?

Answer 15

Becomes impossible to produce in the same form. When a sector for the rest of the world is added all of the above sectors are sub-divided.

Some domestic production is sold abroad (exports, X)

Some domestic income is spent on goods and services produced abroad (imports, IM)