SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 2)

Spending, Saving, Borrowing, and Lending (part B)

by

Charles Lamson

A Typical Household

J. P. Young holds an MBA degree and works as a middle manager at All Purpose Enterprise Inc., better known as APEI. Exhibit 1 summarizes J.P.'s receipts and expenditures during 2016. Such a summary is often referred to as an income statement or a statement of the sources and uses of funds. The right hand side of the table shows the total of J. P.'s receipts called disposable personal income---and the various sources of this income. APEI paid J. P. $47,000 in wages and salary over the year, and he received an additional $5,000 in the form of dividends and interest on stocks and bonds that he owns.

1 - Financial Statement of J. P. Young, January 1, 2016 through December 31, 2016

Expenditures (Uses)	$	Receipts (Sources)	$
Consumption	$44,000
(spending on goods and services)		Wages and salaries	$47,000
Saving	$ 8,000	Dividends	$ 3,000
(acquisition of summer home)	$ 5,000
(acquisition of financial claims)	$ 3,000	Interest	$ 2,000
Consumption plus saving	$52,000	Rent	$        0
		Disposable income	$52,000

On the expenditures side of the table, we can see that J. P. spent $44,000 on goods and services; household spending on goods and services is called consumption. J. P. saved the remaining $8,000 of income; he used $5,000 of this amount for investment in new housing, so he had $3,000 in surplus funds, that were available to be loaned in financial markets. Since disposable personal income must by definition be either consumed or saved, saving is equal to disposable personal income minus consumption. In general, such saving will take four forms. First, J. P. can make investments, such as purchasing a new house. Secondly, he can purchase additional stocks and bonds. These items represent financial claims on the issuer/borrower by the holder/saver. Thirdly, J. P. can place funds into a financial intermediary, such as a commercial bank or savings and loan. Here, his deposit represents a financial claim on the intermediary (it owes). Finally, J. P. can hold cash balances in the form of currency buried in the backyard or hidden under a mattress or elsewhere.

A Typical Firm

All Purpose Enterprise Inc. (APEI), in business since 1902, had a good year in 2016. With its profits up from the previous year, and the business outlook bright, it decided to expand its scale of operations by building a new plant and acquiring additional inventories. Exhibit 2 summarizes APEI's financial transactions during 2016.

Part (A) of the exhibit shows the total revenue received from the sale of APEI's various products to consumers like J. P.  All figures are in millions of dollars. To calculate profits, we have to subtract total expenses from the sales figure. Such expenses include the payment of wages and salaries to workers, and the payment of interest to bondholders. Note that such expenses for firms are income for the recipient households. With sales totaling $5,900 million and expenses totaling $5,400 million, net income is $500 million dollars, as shown in Part (B) of the exhibit. Given this profit performance and the outlook for future sales, APEI's managers recommend, and the board of directors approves, a dividend payment of $300 million to stockholders, and a $500 million dollar expansion project. The investment spending, which is the purchase of the new plant and additions to inventory, will be financed as shown in Part (C) of the exhibit, by issuing $300 million of new bonds and using the $200 million of retained earnings. Who will buy the bonds? The answer; households like J. P. and financial intermediaries.

*2 Financial Statement of All Purpose Enterprise Inc.January 1, 2016 through December 31, 2016 (in Millions of Dollars)*

(A)	Totalexpenses	$5,400	Total sales	$5,900
	Wages and salaries	4,700
	Interest on debt	200
	Cost of raw materals purchased from other firms	500
(B)	Net income (sales - expenses)	$500
	Minus dividends	300
	Equals retained earning’s	$200
(C)	Business investment spending	$500	Financing:
	Financing		New bonds issued	$300
			Retained earnings	200
				$500

From J. P. and APEI to the Economy as a Whole: Aggregration

Let us assume the economy is made up of 100 million households (of which J. P. is typical) and 1,000 firms (of which APEI is typical). This being the case, we can multiply the relevant values in exhibits 1 and 2 by 100 million or 1,000 as appropriate to determine aggregate values for income and expenditures for our hypothetical economy. Exhibit 3 pulls together the resulting totals for 2016.

Focusing first on the household sector, remember that J. P.'s income was $52,000. When multiplied by a 100 million (the number of households), we get disposable income for the entire household sector of $5,200 billion, the figure shown in the exhibit. Likewise, consumption and saving for the household sector were $43,400 billion and $800 billion, respectively. Of the $800 billion in saving, the households spent $500 billion on investment in housing, and had $300 billion in surplus funds available to lend. Here again the appropriate multiplication yields the totals shown in the exhibit.

3 National Income and Expenditures for Our Hypothetical Economy, 2016 (in Billions of Dollars)

Sector	Income	$	Expenditures	$	Income - Expenditures = Deficit or Surplus
Households	Disposable personal income	$5,200	Consumption expenditures Investment expenditures	$4,400   $500	Surplus   $300
Business firms	Retained earnings	$200	Investment expenditures	$500	Deficit    -$300
Economy	National income	$5,400	Domestic product	$5,400

Turning to the business sector, we multiply APEI's returned earnings ($200 million) by the number of firms (1,000) and get $200 billion, which is total retained earnings. (Note that the rest of firms' income was paid to households as dividends, and has already been counted as household income.) In the expenditures column, the $500 billion of investment spending is equal to APEI's $500 million of investment spending, multiplied by 1,000 firms. We assume that $500 million of investment spending is typical for each firm. The $300 billion excess of total investment spending over total retained earnings is the business sector's deficit; it will be financed by issuing bonds.

The relevant totals for the economy as a whole are calculated by simply adding up their relevant columns. The totals are given in the last row of exhibit 3. More specifically, to calculate national income ($5,400 billion), we add household disposable income ($5,200 billion) to firms retained earnings ($200 billion). Similarly, to calculate total expenditures on output ($5,400 billion), we add together consumption ($4,400 billion) and investment spending ($1,000 billion = $500 billion investments by households + $500 billion investment by businesses). Finally, we can see in the last column that the deficit in the business sector ($300 billion) is exactly offset by the surplus in the household sector; in other words, the amount of bonds sold equals the amount of bonds bought.

So what is the point of all this? Typically, households and firms meet in three separate, but related, market arenas. First, there is the product market. Firms produce and sell goods and services; they are the suppliers in the product market. Households purchase goods and services through consumption spending and investment in goods, such as new houses. In addition firms purchase new capital goods, and addition to inventory, through investment spending. together households and firms are the demanders in the product market. Second, there is the factor market for labor, capital, and natural resources. If we focus on labor, in particular, households are obviously the suppliers of labor services and firms engaged in production are the demanders. Third, and finally, there is the the financial system: DSUs (deficit spending units), such as APEI, are the demanders of funds; SSUs (surplus spending units), such as J. P. Young, are the suppliers of funds.

Our economy is populated with millions of J. P. Youngs and thousands of APEIs. Each makes spending, saving, borrowing, and lending decisions. When we add them together---that is, aggregate---we have the total demand for goods and services, the total supply of funds, the total demand for labor, and so forth. These supplies and demands produce the flow of income, expenditures, and funds depicted in our example. National income is the sum of the resulting earnings in each sector. Summing the expenditures in each sector gives us national expenditures on the final output of goods and services (domestic product). And since, in this simplified economy, whatever is spent is received by someone, national income equals national 

expenditures. Given these economywide relationships.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 63-65*

END

Expenditures (Uses)

$

Receipts (Sources)

$

Consumption

$44,000

(spending on goods and services)

Wages and salaries

$47,000

Saving

$ 8,000

Dividends

$ 3,000

    (acquisition of summer home)

$ 5,000

     (acquisition of financial claims)

$ 3,000

Interest

$ 2,000

Consumption plus saving

$52,000

Rent

$        0

Disposable income

$52,000

(A)

Totalexpenses

$5,400

Total sales

$5,900

Wages and salaries

 4,700

Interest on debt

    200

Cost of raw materals purchased from other firms

    

     500

(B)

Net income (sales - expenses)

    $500

Minus dividends

   

      300

Equals retained earning’s

    $200

(C)

Business investment spending

    $500

Financing:

Financing

New bonds issued

$300

Retained earnings

 200

$500

Sector

Income

$

Expenditures

$

Income - Expenditures = Deficit or Surplus

Households

Disposable personal income

$5,200

Consumption expenditures

Investment expenditures

$4,400

  $500

Surplus   $300

Business firms

Retained earnings

  $200

Investment expenditures

  $500

Deficit    -$300

Economy

National income

$5,400

Domestic product

$5,400