THE MACROECONOMIC

CIRCULAR FLOW

PART II

We will now add the Business Sector to the model.

We can do this by including the Business Sector in the same icon we used for Households.

HouseholdsBusinesses

WAGES

PRODUCT MARKET

SPENDING (GDP)

By simplifying, we can split total income into two broad streams.

Income to Households we’ll call “Wages.”

Income to Business we’ll call “Profit.”

HouseholdsBusinesses

PROFIT

INCOME

WAGES

INCOME

We could continue to keep the business and the household sectors separate, but it turns out:

1. this isn’t terribly helpful for our purposes, and

2. It makes the diagram pretty messy

PRODUCT MARKET

SPENDING

Uses of Income

Uses of Income

Current DomesticSpending

HouseholdsBusinesses

PROFIT

INCOME

CONSUMPTION

DOMESTIC

PRODUCT MARKET

SPENDING

1. Don’t Separate Income into Profit and Wages

2. Combine Households and Businesses into the Domestic Private Sector

3. Combine the spending streams of Households and Businesses – call it Consumption

4. Combine all the other uses of Households and Businesses income.

SO LET’S SIMPLIFY

Other Uses of IncomeDOMESTICPRIVATESECTOR

INCOME

CONSUMPTION

DOMESTIC

PRODUCT MARKET

SPENDING

Other Uses of Income

So ... what are the other uses of income

Remember ...Each of these is the combination of income used by Households and by Businesses

TAXES

SAVING

IMPORTSDOMESTIC

PRIVATESECTOR

INCOME

CONSUMPTION

DOMESTIC

PRODUCT MARKET

SPENDING

INCOME

TAXES

SAVING

IMPORTS

We can add back the three other types of spending

GOVT

INVESTMENT

EXPORTS

DOMESTIC PRIVATESECTOR

INCOME

TAXES

SAVING

IMPORTS

CONSUMPTION

DOMESTIC

LEAKAGES

INJECTIONS -- the sum of Exports, Investment and Government Purchases

LEAKAGES --the sum of Imports, Saving and Taxes

PRODUCT MARKET

INJECTIONS EXPORTS

INVESTMENT

PURCHASES

GOVT

TWO MORE TERMS

DOMESTIC PRIVATESECTOR

INCOME

TAXES

SAVING

IMPORTS

CONSUMPTION

DOMESTIC

LEAKAGES

PRODUCT MARKET

INJECTIONS EXPORTS

INVESTMENT

PURCHASES

GOVT

INJECTIONS – appear to come “from nowhere.”

LEAKAGES –appear to go “to nowhere.”

HOUSEHOLDSAnd

BUSINESSES

INCOME

TAXES

SAVING

IMPORTS

CONSUMPTION

DOMESTIC

LEAKAGES

PRODUCT MARKET

INJECTIONS EXPORTS

INVESTMENT

PURCHASES

GOVT

Because spending and income can come from and go to “nowhere” we call this the OPEN MODEL

HOUSEHOLDSAnd

BUSINESSES

PrM

Again, let’s simplifying the diagram for drawing purposes. Here’s one version --

H/B

C

Injections

Leakages

X

Y

E I G

F S T

PrM

Here’s another simplified version --

H/B

C

Injections = E + I + G

Leakages + F + S + T

X

Y

INCOME CAN BE EXPRESSED IN TWO WAYS

1. Where does it come from --

Income = Wages + Profits

= from “working” + from “owning”

2. Where does it go --

Income = Consumption + Leakages

= back to the Product Market (Consumption)

+ to “somewhere else (Leakages)

SPENDING CAN BE BROKEN INTO TWO TYPES

Spending = Consumption + Injections

= from Income + from somewhere else

THE CLOSED MODEL

and

MARKETS

A somewhat different view from the open model stresses the idea that income does not escape from the economy, but

instead is kept circulating within the economy.

There are four macroeconomic markets

1. The Product Market – where goods and services are produced and sold.

3. The Credit Market –

where people with money to lend contact people who want to borrow: banks, the stock market, credit unions, etc.

4. The Foreign Exchange Market –

where the currencies of different countries are exchanged in order to to make trade possible. Think of the Foreign Exchange Market as the way we talk to the rest of the world.

2. The Labor Market – where workers are hired

INCOME (Y)

INCOME(Y)

PRODUCT MARKET

The PRODUCT MARKET refers to all the stores and factories in the economy. Money enters the market as spending and is paid out as income to Households and Businesses.

Households And

Businesses

SPENDING (X)

Most Income is then sent back to the Product Market as Consumption.

CONSUMPTION(C)

PRODUCT MARKET

The LABOR MARKET splits total Income into two parts: Wages, going mainly to Households, and Profits, going to Businesses and their owners.

Households And

Businesses

SPENDING (X)

PROFIT

WAGES

LABOR MARKET

C

INCOME (Y)

INCOME

PRODUCT MARKET

The CREDIT MARKET exists to link savings and investment.

H/B

SPENDING (X)

C

INCOME (Y)

CREDITMARKET

Savings(S)

INVESTMENT(I) The part of

income that is not spent (that is saved) goes in to the Credit Market (banks and other saving institutions). Businesses borrow from there to invest (buy capital).

PrM

H/B

SPENDING(X)

C

INCOME(Y)

FxM

Imports(F)

Exports(E)

Dollars leave the US to pay for our Imports from other countries.

Dollars return to the US when other countries pay for our Exports.

The FOREIGN EXCHANGE MARKET exists to allow trade between countries with different currencies.

PrM

H/B

SPENDING(X)

C

INCOME(Y)

The TREASURY is the part of the government whose job is (among other things) to collect taxes, pay for government purchases and borrow money to fund the government.

TRSY

Taxes(T)

Gov’t Purchases

(G)

Budget Balance

(BB)

Taxes are taken from Income

Gov’t Purchases are part of spending

The Budget Balance usually refers to the “Budget Deficit,” the amount the gov’t has to borrow per year.

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

THIS MODEL IS CLOSED

But we need to add two more important flows

of credit

A budget deficit occurs if the government spends more than it takes in as taxes.

The government must then borrow this amount.

Money goes from the Credit Market into the government Treasury.

A budget surplus occurs if the government spends less than it takes in as taxes.

The government can then lend this amount. Money goes from the Treasury into the Credit Market.

1. THE BUDGET BALANCE (BB)

A Budget Deficit (when Purchases exceed Taxes) goes from the Credit Market to the Treasury.

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

The Budget Balance in

THE CLOSED MODEL

The Gov’t Budget Balance

BB

A Budget Surplus (when Taxes exceed Purchases) goes from the Treasury to the Credit Market.

A Foreign Capital inflow (Kin) occurs when the US borrows dollars from the rest of the world.This happens when rest of the world has an excess of dollars.

This is the case when the US imports more than it exports.

A Foreign Capital outflow (Kout) occurs when the US lends dollars to the rest of the world.This happens when the rest of the world is short of dollars.

This is the case when the US imports less than it exports.

2. Foreign Capital Flows (K)

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

Foreign Capital Flowsin

THE CLOSED MODEL

K

A foreign capital outflow goes from the US credit market to the rest of the world, through the Foreign Exchange Market

A foreign capital inflow goes from the rest of the world,

through the Foreign Exchange Market, to the US Credit Market.

Foreign capital can be either an inflow or an outflow

Putting this all together we have the

CLOSED MODEL

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

THE CLOSED MODEL

K BB

Only two more pieces to go.

1. The Money Supply and The Federal Reserve.

The Federal Reserve (known as “The Fed”) is the government agency whose job it is to control the quantity of money and credit available in the economy.

We will picture them as a part of the Credit Market, able to add or take money from the banking system.

THE FEDERAL RESERVE and the MONEY SUPPLY

To keep things simple we’ll ignore the Foreign Sector and the Treasury

H/B

I

PrM X

C

Y

CrM

SThe FED

ΔMS

This shows an increase of the money supply. Newly printed money comes out of the Fed and in to the Credit Market

THE FEDERAL RESERVE and the MONEY SUPPLY

H/B

I

PrM X

C

Y

CrM

SThe FED

ΔMS

This shows a decrease of the money supply. The Fed takes money out of circulation.

2. Money Demand, Liquidity and the Velocity of Money.

The last component of the model is the public’s desire to hold money – to be liquid – as opposed to lending money. This is represented by the “Cash Box.”

How much money the public (including banks) wants to hold is related to the question of how quickly money moves through the economy, how fast a dollar goes around the circular flow diagram. This concept is called the velocity of money

Money going into the Cash Box represents:a. an increase of the demand for money (people are holding more)b. a decrease of the velocity of money (money is moving slower)

Money coming out the Cash Box represents:a. an decrease of the demand for money (people are holding less)b. an increase of the velocity of money (money is moving faster)

THE CASH BOX and MONEY DEMAND

H/B

I

PrM X

C

Y

CrM

SCash

ΔMD

This shows a decrease of the money demand. The public holding less money. The velocity of money is rising.

THE CASH BOX and MONEY DEMAND

H/B

I

PrM X

C

Y

CrM

SCash

ΔMD

This shows a increase of the money demand. The public is holding more liquidity. The velocity of money is falling.

Once you add the Money Supply and Money Demand into the model, the terminology of “open” and “closed” model doesn’t apply.

So we now have three classes of Models

1. Open

2. Closed

3. Money

1.Basic – this includes Income, Spending, Consumption, Saving and Investment. These variables appears in every model.

2. The Treasury – this adds Taxes, Government Purchases and the Budget Balance.

3. The Foreign Sector – this adds Imports, Exports and Foreign Capital Flows.4. The Money Supply – this adds the Federal Reserve.

5. Money Demand – this adds Liquidity and the Velocity of Money.

You can imagine any of these being models as being built up from a set of components.

REMEMBER THE RULE.

The simplest model that works is the best one to use.

THE END ... for now