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