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Injections and leakages approach to determining equilibrium income - YouTube
Channel: EnhanceTuition
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In this video we will learn about the leakages
and injection approach to equilibrium.
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In every economy there will be leakages and
injections into the circular flow of income.
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If more money is leaving (leakages) than entering
(injections), then real GDP will tend to fall.
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However, if more is entering (injections)
than leaving (leakages), then real GDP will
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tend to rise.
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Let鈥檚 refresh our knowledge of leakages
and injections. The leakages out of the circular
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flow include savings, taxation and import
expenditure. The injections into the circular
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flow of income include investment, government
spending and export revenue.
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From this point forward, I will use the letter
listed next to each to refer to the specific
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leakage or injection.
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To understand why an economy would be in equilibrium
when withdrawals equal injections we need
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to go back to equilibrium in the aggregate
expenditure model, which occurs where Y, or
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national income is equal to AE, or aggregate
expenditure
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Aggregate expenditure is equal to consumption
plus investment plus government spending plus
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net exports.
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Y is equal to national income, which is earned
by households. These households then use their
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income to consume, save or pay taxes.
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Now we can set our national income equal to
our aggregate expenditure.
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To be at equilibrium, consumption plus savings
plus taxation should equal consumption plus
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investment plus government spending plus export
revenue minus import expenditure.
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We add import expenditure to the left side
of our equation and eliminate the C, which
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exists on both sides.
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That leaves us with savings plus taxation
plus imports, or our leakages being equal
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to investment, government spending and export
revenue, our injections.
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So in order to determine equilibrium using
this approach, we look for the point at which
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leakages equal injections. Note that this
equation applies to an open economy with international
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trade.
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We鈥檒l look at closed economies later in
this video. Now let鈥檚 see how this appears
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on a graph.
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Our y axis represents leakages and injections,
whereas our x axis represents real GDP.
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Remember that at low levels of real GDP, dissavings
occurs which is why our leakages have a y
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intercept of聽 鈥揳. A represents autonomous
consumption, or consumption irrespective of
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income. Thus, with zero income spending would
come from borrowing or dissavings.
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Our injections are represented by a horizontal
line that occurs above zero. This line represents
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the sum of all our injections.
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Where the leakages and injections intersect
is our equilibrium level of real GDP or real
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national income, Y.
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Before Y, injections exceed leakages, so firms
will continue to increase production until
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the economy reaches output level Y.
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Beyond Y, leakages exceed injections, so firms
will decrease production until the economy
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reaches output level Y.
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Here I鈥檝e given the general terms, leakages
and injections but we鈥檒l now look at what
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happens in two, three and four sector economies.
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The two sector economy is closed and consists
of households and firms only.
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The only leakage in this model is savings
whereas investment is the only injection.
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We鈥檇 use the exam same diagram as before
but just label the two lines more specifically
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as seen here.
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In the three-sector economy, it is still closed
but adds in government.
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The two leakages in this model include savings
and taxation, whereas the two injections are
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investment and government spending.
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Just as before, we add more detail to our
labels.
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Finally, we have the open four sector economy
which includes international trade.
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This is exactly the same as the formula I
introduced at the outset of the video. Three
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leakages, savings, taxation and import spending
and three injections of investment, government
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spending and export revenue.
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Here we have the diagram again updated with
accurate labels.
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Here鈥檚 a chance to demonstrate what you鈥檝e
learned thus far. If you can answer the two
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problems that follow, you鈥檙e making good
progress and have learned what you needed
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to from this video.
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Problem 1
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Suppose there is a closed economy with no
government.
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Draw a diagram using the leakage and injection
approach to demonstrate equilibrium income.
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Now assume that the level of savings rises
for households.
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Draw the change and indicate the impact on
the equilibrium level of income.
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Pause the video here, try to answer it and
the solution will follow momentarily.
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Your starting point should be this diagram
of the closed two sector economy.
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We know that savings has increased at each
and every level of real national income or
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real GDP.
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Let鈥檚 see what impact this will have.
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The leakages line will shift upwards to S1
and this results in a lower equilibrium real
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national income represented here by Y1.
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Did you get this one right? If not, work through
it again and see what went wrong.
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Problem 2
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Suppose there is an open economy.
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Draw a diagram using the leakage and injection
approach to demonstrate equilibrium income.
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Now assume that the level of exports rises.
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Draw the change and indicate the impact on
the equilibrium level of income.
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Pause the video here, try to answer it and
the solution will follow momentarily.
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Your starting point should be this diagram
of the open four sector economy.
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We know that exports have increased at each
and every level of real national income or
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real GDP.
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Let鈥檚 see what impact this will have.
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The injections line will shift upwards and
this results in a higher equilibrium real
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national income represented here by Y1.
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If you got this one right too, you鈥檙e doing
well.
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After practicing these two problems and watching
this video you should have a better understanding
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of the leakages and injections approach to
determining equilibrium. If you have any questions
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or comments, leave them below and let鈥檚
try and answer them together. That鈥檚 us
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done for now and I will see you in the next
one.
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