Download Circular Flow part1

THE MACROECONOMY
A CIRCULAR FLOW DESCRIPTION
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A simple picture of a single household
Income enters the household, mostly as the wages that the
members of the household earn.
Most income leaves the household as consumption.
(“Consumption” is the name for household spending.)
I
N
C
O
M
E
A
Household
CONSUMPTION
It is generally true that if a household’s income increases,
its consumption will also increase.
I
I
N
N
C
C
O
O
M
M
E
E
A
CONSUMPTION
CONSUMPTION
Household
It is NOT, however, true that a household’s income will
increase because it consumes more.
(Try it – buy a new car and then tell your employer that you
want a raise because you are spending more. It usually
won’t work!)
I
N
C
O
M
E
A
CONSUMPTION
CONSUMPTION
Household
Your income comes from one place – from your work –
and your consumer spending goes to a different place – to
the places where you shop.
We now turn to MACROECONOMICS
a look at the “whole” economy.
In Macroeconomics we won’t look at a single household.
We will look at the
HOUSEHOLD SECTOR
Think of this as all households taken together.
We will add another part of the economy. This is the
PRODUCT MARKET.
Think of this as all the factories and stores in the economy
Now consider an interesting fact. Our income comes from
the Product Market – where we work and …
our spending goes to the Product Market – where we buy
goods and services.
We can simplify a bit and say that in macroeconomics
INCOME AND SPENDING ARE THE SAME THING
Your income is someone else’s spending.
Your spending is someone else’s income.
Taken as a whole
OUR INCOME IS OUR SPENDING
Our simple macroeconomic diagram looks like …
PRODUCT
MARKET
SPENDING
I
N
C
O
M
E
HOUSEHOLDS
INCOME
C
O
N
S
U
M
P
T
I
O
N
You can see why this is
called a circular flow
diagram.
The essential fact of a
macroeconomy is that
“the money goes
around,” ... and around,
and around, and ...
Income becomes
spending, which
becomes income,
which becomes …
When you actually draw this by hand (and learn a lot of
abbreviations) it will look something like this ...
PrM
X
C
H/B
Y
You will use these
diagrams a lot. You
want to be able to draw
them simply and
quickly.
In fact, once you get
used to them, you can
even leave off all the
labels (Y, C, PrM etc.)
To repeat: The household sector is like a household because -If your income rises, you will probably spend more.
If our income rises, we will probably spend more.
BUT …
If your spending rises, you will not get more income.
If our spending rises, we will get more income.
So the household sector is not just like one large household.
The circularity of macroeconomics – where spending becomes
income -- does not exist for the individual household.
We can now add to our diagram (we can call it a “model”)
more detail. We need to include …
The Four Sectors
Names for their Spending
1. The Household Sector …...… 1. Consumption
2. The Business Sector ……….. 2. Investment*
3. The Foreign Sector ……...…. 3. Exports and Imports**
4. The Government Sector …… 4. Government Purchases
* The word “investment” has a particular meaning in economics.
Investment, in economics, means “the purchases by the business
sector of machines, factories and inventories.”
** Exports are what we sell to other countries. Imports are what
we buy from other countries
Total Spending in the economy is measured by the most
important macroeconomic statistic –
Gross Domestic Product (GDP), which is defined as ..
“The dollar value of all final goods and services produced in an
economy in some time period (generally one year).”
GDP is broken down into the four types of spending.
GD P = Total Spending =
Consumption* + Investment + Exports + Government Purchase
* In an unusual use of words, in this class we will typically use
the word “consumption” to mean only the purchases of
domestically produced goods
We can add these types of spending to the model to get …
PRODUCT
MARKET
SPENDING (GDP)
I
N
C
O
M
E
HOUSEHOLDS
INCOME
C
O
N
S
U
M
P
T
I
O
N
E
X
P
O
R
T
S
I
N
V
E
S
T
M
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N
T
G
O
V
T
P
U
R
C
H
Until now we have assumed that all of the household sector’s
income is consumed, buying domestic goods. Clearly this is
not true. We now describe the four uses of income.
The Four Uses of Income
1. Consumption
2. Saving
3. Imports
4. Taxes
We can add these uses of income to the model to get …
PRODUCT
MARKET
I
N
C
O
M
E
HOUSEHOLDS
SPENDING (GDP)
This is the
OPEN
MODEL
See the next
slide for
drawing
tips.
INCOME
C
O
N
S
U
M
P
T
I
O
N
E
X
P
O
R
T
S
I
M
P
O
R
T
S
I
N
V
E
S
T
M
E
N
T
G
O
V
T
S
A
V
I
N
G
T
A
X
E
S
P
U
R
C
H
A hand drawing of this model looks more like this --
PrM Spending
Exports
Investment
Government
Purchases
Saving
Taxes
Consumption
Imports
H/B
Income
This is the end of part 1 of the Introduction.
Feel free to continue on to part 2.
But maybe you ought to take a
moment to stretch first.