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Macroeconomic Measurements
Aggregate Output and Income
The Circular Flow Model
Page 1 of 2
So I was just at the grocery store and I got this dollar bill in change, and it says “Lucy” on it. And you have to wonder
where is Lucy now? And why did she write her name on this dollar bill? And you can’t help but wonder where all this
has been and how many people have touched it besides Lucy who chose not to write their name on it.
If you think about money, you start to be drawn into the way it circulates in our economy, that it’s been in so many
other people’s hands, and the next time I spend it, it’s going to go into someone else’s hands who’s going to wonder
about Lucy. Every time you spend money, you’re creating income for someone else. At the grocer just now, when I
paid for my groceries, my spending became his income. Of course, some of it was his, but some of it went to pay for
the foods that he had stocked his shelf with, some of it went to pay his workers, but some of it was his income; my
spending became his income.
And when you add up the aggregates in the economy, it must be true that in a given period of time, the total amount of
spending is equal to the total amount of income. This is one of the most basic, fundamental concepts in
macroeconomics. And to understand this concept better, we’re going to build a circular flow diagram to show the way
that money circulates through the economy and the complementary circle – the circle of resources – through the
economy. Because money moves in one direction to pay for stuff which is moving in the other direction; and you can
see this more clearly when you put it all down at once in a picture.
So let’s build a circular flow diagram, and we’ll start with households. Household purchases of goods and services is
called consumption, and the households purchase goods and services with money. They acquire the money by selling
their resources – land, labor, capital – and they sell these resources in the market for factors – the factors of
production, or the resource markets. The second set of players in our circular flow diagram are the firms or
businesses. Firms or businesses hire the factors of production, and transform this land, labor, and capital into the
goods and services that households purchase. Firms pay for the factors of production with money. This money
becomes the income of the household, which they then use to purchase the goods and services that the factories
make.
We’re going to look now at the interaction of households and firms in these two distinct markets. First, we’ll look at the
markets for the factors of production. Households supply resources, and I’ll use red to indicate the flow of resources.
Land, labor, and capital flows into the factor markets from the households. Over in the factor markets, this land, labor,
and capital is hired by firms who then put these resources to work producing goods and services.
Now, the complementary flow to this flow of resources from households through the factor markets into firms is the
flow of money. Businesses pay for these resources with money; and this payment takes the form of wages, interest
payments, rental payments for property, and profits that are returned to households who own stock in the companies.
So in the factor markets we see resources flowing in one direction and money payments for the use of those
resources flowing in the other direction. The other market in which firms and households interact is the market for
goods and services. In this market, goods and services are provided by the firms, and purchased and enjoyed by the
households. So the resource flow in this direction is clockwise. The money flow is in the other direction – households
pay money for goods and services, and that money winds up as the revenue of businesses; and out of this revenue,
businesses pay wages, interest, etc., over in the factor markets.
You see now that we’ve got a complete circle. Money begins as the factories pay wages and interest payments to the
households, their income. And this income, then, is used when the households buy goods and services in this market.
Then it becomes the revenue of factories. So money flows around the circle counterclockwise. Resources flow the
other direction – households supply land, labor, and capital to businesses that transform them using their technology
into goods and services that wind up back in the households. That’s the circular flow – resources in one direction,
money in the other direction. And looking at this picture, it should be clear that spending and income are equal, and
have to be, because this is a closed system.
Now, we can add other players to our story, and see how that complicates the circular flow. The first candidate for
being added to the model is the government. And the government interacts in this circular flow in several directions.
Macroeconomic Measurements
Aggregate Output and Income
The Circular Flow Model
Page 2 of 2
First of all, the government buys goods and services from the goods and services markets, and the government hires
factors of production, like land, labor, and capital, in order to run the government, hires them from the resource
markets. The government pays money to its employees and other people who sell it factors of production, and the
government pays money for the goods and services that it purchases to run the government.
Households pay money to the government in the form of net taxes. I say net taxes because the government also gives
some money back to households in the form of welfare payments, unemployment insurance, medical payments, and
so forth. But on net, households pay taxes into the government in the form of cash. In the other direction, the
government supplies services to households in the form of schools and roads and bridges and national defense and
other public goods.
Over here on this side we have the same story. Firms pay taxes to the government on net, although some firms get
subsidies from the government. On net, however, the flow of money is from firms into the government in the form of
taxes. The flow the other direction is the government providing goods and services to firms. Not only do firms use
roads and bridges, but firms also profit from the court system and laws and contracts and such things that are
enforced by the government. So national defense, security services, all of the things that are provided publicly, flow
back from the government in the form of resources, goods, and services, to the business sector.
So we put the government here in the middle. Notice the government has a nice interaction and integration into this
system with money and resources flowing as you might expect.
We can also introduce one other player into this story, and that is the rest of the world. The rest of the world means
people in other countries who want to buy and sell goods and services to people in the United States; that is,
companies in the U.S. and private households buy goods from abroad – imports – and businesses here in the U.S.
sell products – exports – to people in other countries. So for the rest of the world, notice that we have two ways of
thinking about the interaction. We’ve got imports coming into our goods markets from abroad, and we’ve got goods
going back out as experts. So the top arrow here represents the imports into the economy; the bottom resource arrow
represents exports out. Money flows in the opposite direction. Whenever we import goods, we send money abroad to
pay for it. And when we export goods, money comes back in.
And there you have it, a complete circular flow diagram that shows how all of the players in the macroeconomy
interact with one another. The main insight you get from studying this picture is that spending equals income. It’s a
closed system, it’s like a set of plumbing pipes and all the water sloshes around, but eventually there’s only a certain
amount of water in the whole system. And anytime you go to the store and you pay for something, when you’re
spending, money is going into the hands of a merchant to become his or her income. It’s that simple. And in the
aggregate, when you add up everything that people are spending, and everything that people are receiving as
income, the two numbers are necessarily always equal. Spending equals income – we’ll be building on this concept
throughout our study of macroeconomics.