Download A Circular Flow Diagram

A Circular Flow Diagram
Topic
Basic four box
Seven Box
Slides
2-20
21-60
Leakages/Injections 61-67
Questions
68-75
McCaffery © F15
OK, so maybe that was TOO much, too soon. As
with any teacher, I only wanted your attention.
We will cover a more basic diagram and then an
optional diagram that includes what has recently
been asked on the AP exams about circular flows.
To start taking notes you need at least 2/3rd of an
sheet of paper, better yet a fresh sheet.
This will be a large circle with four evenly spaced
boxes around the perimeter.
So eye-up your page and put two boxes as shown
on the next page.
Firms and Households
Firms buy stuff, do
something to that stuff,
and offer it for resale.
Households buy stuff for
final consumption.
FIRMS:
HOUSEHOLDS:
Buy hamburger, make
burgers, and sell them.
Buy hamburger, eat it, and
flush it away 24 hours later.
Final consumption.
OK, so we have two of our four boxes. Now we need
to add arrows showing flows of stuff and money.
Firms make and offer goods and services on the
market place hoping to sell them. Firms are the
suppliers.
Households go to the market place to buy the
goods and services they desire. Here households
are the demanders.
The supply and demand for goods and services
meet in the Product Market.
Product as in production or to produce.
A market is a market because the forces of S&D
operate within it. A few more modules from here and
you will discover that this S&D pair is Aggregate Supply
and Aggregate Demand. AS and AD are very important
for macroeconomics.
The households showed up with cash and walked
away with goods and services.
The firms showed up with goods and services and
exchanged them for cash.
So much for the top half of the graph. Both C for
household consumption and NP are measured in
dollars while the other two arrows are the goods and
services. And both are ‘official’ abbreviations that can
be used with in your written answers without defining
them.
Households offer their
labor for sale acting as
the suppliers. Labor is
one of the Factors of
Production: Land,
Labor, and Raw
Materials.
Firms, acting as the
demanders, need F of P
to produce their output
and offer reimbursement
to potential workers.
The two forces of S and D
meet in the Factor Market.
This S&D would be for
labor and is a micro model
found in module 71.
HH = Suppliers
Firms = Demanders
Households provide their
labor to the firms.
Firms pay the households
for their labor. This payment
is National Income.
Weasel Puss Is Red.
Households receive their pay in four forms, by size they
are: Wages, Profits, Interest, and Rents.
Wages = money, and all other benefits. Profit, Interest,
and Rents all go to households because they own
firms. So a patent payment to IBM ultimately goes to
the households who own IBM stock
Weasel Puss Is Red.
And taxes? Don’t firms pay corporate income taxes?
Any taxes paid by firms is assumed for this model to
have been paid by the owners of the firms, households.
If you think about for a while, it is true. A $1 reduction
in corporate tax would translate into a $1 increase in
profit going to HH. So who paid that tax? HH
By definition NP = NI.
Half of the AP questions
on the circular flow can be
answered using this fourbox, eight-arrow model.
Time is a very important concern.
You may want to end the end circular flow
learning now and jump to the AP style questions.
However, there have been AP exam questions
about leakages and injections.
I go further because I think it helps with:
Budget deficits
Trade deficits
Capital flows
Fiscal policy multiplier
LEAKAGES and INJECTIONS (AP flow material)
Ouch, there it is
again.
It is not that
complicated if you
look at it piece by
piece.
Don’t get tied up in
knots over real life
examples. This is a
model of how money flows in an economy. Banks are
firms, but what they do is part of the financial market. All
taxes are shown as being paid by HH, which as we said
earlier has some fact to it. All Investment Spending is
done with borrowed money? Probably not. I is only a
model.
Stick with the earlier
definitions for firms
and households.
Don’t get into a mess
explaining how a
person operating a
business out of their
house gets counted.
The IRS has pages
and pages
delineating how to
count that situation.
To continue we will only
use arrows representing
money flows.
Many economists say
that ignores the
importance of the it all…
the stuff.
The four boxes and
arrows are the core of
the circular flow. Most of
the arrows we will add
are leakages from or
injections to this core.
For note taking… a full
sheet of paper using the
top two-thirds for the
diagram. The bottom
third for explanations.
Get these four boxes
and arrows spread out
on your sheet and leave
room for the blue box
A model of an economy
wouldn’t be complete
without government
having a seat.
This is to represent all
government, but it
easiest to think of it as
only federal.
Label the arrow NET
TAXES. I will explain
next page.
TAXES
-TRANSFER PAYMENTS
NET TAXES
Households pay taxes to the government and many
households receive money from the government in the
form of Social Security, tuition grants, food stamps, farm
subsidies, etc. So money goes in as taxes and transfer
payments come back. Transfer payments is a nice term.
No connotations. Transfer payments go to people we
like. Welfare goes to people we don’t know.
Government purchases
goods and services.
Government spending
-Transfer Payments
Government purchases
GP + TP = GS
Those 3 are not official
abbreviations.
All of government spending is the sum of transfer
payments and government purchases. Be cognizant
of using government spending when you really mean
government purchases. Using GS leads to ‘double
counting’ spending. Once as a transfer payment and
once as consumption by households spending it.
It gets crowded fast now,
so explanations will
follow the red addition.
T, C, and S are
‘official’
abbreviations.
The Financial Marker is an often over looked piece
of our economy, because it usually operates so well.
Households do three things with their income: pay
taxes (T), consume (C), and save (S). Savings goes
into the financial markets.
The market inside this box is the Loanable funds
market which you will meet in module 29.
Loanable funds market, bond market, stock market,
pensions, life insurance with a saving component,
mortgage market, etc; these are all parts of the
Financial Market. Odds are you have not studied any
of these specialized markets… yet.
Net Savings. I bet you have an idea what I am going
to say. Some households save, others borrow, and the
difference is net savings.
Savings
-Borrowing
Net Saving
It gets even a bit more funky. A household can be
saving in their 401k or IRA for old age and at the same
time be borrowing money to pay for a house, home
remodel, car, or tuition. Many households both save
and borrow in the same year.
Taxes = GS = balanced
budget
T > GS = government
saves
a government surplus
T< GS = government
borrows
a government deficit
This could be called net government saving or net
government borrowing, but only twice since 1969 has
the US government run a surplus and been a net
saver, so we will stick with just Government
Borrowing.
Every week the US government pays off some old
bonds as they mature (saving) and every week the
government goes to the bond market to borrow. But
for our purposes we can concentrate on only the term
government borrowing. AP has been happy with
government borrowing.
That is Investment Borrowing. And true, firms are
both paying off old debt (saving) and borrowing for
new expansions. Financial Markets should not lend to
firms so they can ’make payroll’. If a firm can’t pay
their employees, they should be considered too risky
to be eligible for a loan.
So far, we have households, government, and firms as
potential borrowers.
All money that enters a box MUST continue on. In a
case where $100 is saved by households, it could end
up moving-on like this: $25 lent to households, $55
lent to firms, and $20 lent to government. What goes
into a box better come out.
This, ‘the money must continue on’, is an important
point. If money pools in any box it is the same as
blood pooling in a body. You are likely to have a
stroke. In 2008 the US and much of the world had a
financial stroke. First money pooled in financial
markets, then in firms, and finally in households. With
reduced flow, the economy slows.
Firms borrow and use the money for plant expansion.
Another name for plant expansion is increasing Capital
Stock. Don’t get capital stock confused with shares of
stock found on the stock market. Firms are using this
money to buy new plant, machinery, and equipment.
Equipment is mobile, machinery is bolted in place. Non-AP.
You reserved a spot for this market earlier and here it is,
Foreign Markets. The S&D graph in this market that AP
uses is the Foreign Exchange Market (ForEx). The
ForEx market determines the international value of
currencies.
This would make a great question. Why is the Imports
arrow pointing away from the circular flow? Don’t
imports came toward a nation.
The arrows on this graph show the direction of the
MONEY, not of the goods and services.
We import a car, the car comes toward us, but our
payment, our money, goes away from us.
Exports
-Imports
Net Exports
X - M = NX
This really doesn’t need an explanation. We sell them
goods and services and they send us the MONEY.
Now some might be inclined to use Net Exports and
one arrow. Take exports and subtract Imports. And that
would be OK. But we make a big deal about the flows
of M and X so I suggest drawing them separately.
X > M = Trade Surplus
X < M = Trade Deficit
X = M = Trade Balance
M > X = + Cap. Inflow
M < X = - Cap. Inflow
M = X = No Flow
Capital Inflows equals M - X. Yes, I said that correctly. M
- X. This alone is worth a point on the AP exam. If $13
for M flows out, and only $9 flows back through exports,
the foreign economy is ‘stuck’ holding $4 of US currency.
They have already bought all the goods and services
they want, so they LEND the money back to us.
M > X = + Cap. Inflow
M < X = - Cap. Inflow
M = X = No Flow
Why do they lend it back to us? Try spending some
Spanish money downtown. No one will take it. How
about some Polish Zloty? Clerks will look at it and
remark on its beauty, but won’t sell you anything in the
store. Currency is only good in its home nation.*
The USD, being a reserve currency, has special privileges and is
accepted a bit more often than most. Oil can be paid for using USD.
M > X = + Cap. Inflow
M < X = - Cap. Inflow
M = X = No Flow
And one more point. Not all that inflow is lending. Much
of that flow is used to buy stocks, bonds, real estate, and
to build new factory space (foreign direct investment,
FDI). You will learn more about this in module 41.
Wow, now let’s use this flow diagram to find
leakages and injections
LEAKAGES AND INJECTIONS an AP topic
When the exam doesn’t ask about the four boxes and
eight arrows, the basic diagram, they ask about
leakages and injections.
This equation of S + T + M = G + I + X is a very useful
equation. So far, the AP exams only ask that you know
the equation and its components. But it can be used
to do some surprising analysis, such as how it
determines the size of the budget deficit or surplus.
For memory purposes I call it
STEM = GICKS
STM = GIX
LEAKAGES AND INJECTIONS an AP topic
G+I+X
Arrows
pointing
toward the
main flow.
The core flow
being the 4
arrows
connecting the
original four
boxes.
LEAKAGES AND INJECTIONS an AP topic
S+T+M
Arrows pointing
away from the
core flow.
What about
Capital Inflows?
Capital inflows
is already
handled by X
and M.
LEAKAGES AND INJECTIONS an AP topic
If you chase
money around
the flow diagram
you find that
everything
works fine, all
money into
boxes equals all
money out of
boxes, as long
as GIX = STM.
LEAKAGES AND INJECTIONS an AP topic
If GIX ≠ STM
then some box
or boxes are
holding money.
As I stated
earlier, that is
akin to a person
having a stroke.
The economy
may violently
change its size
trying to get GIX
to equal STM.
And that is it. One big, beautiful, circular flow
diagram. Congratulations. Let’s look at some AP
style questions.
#12 In the circular flow diagram,
which of the following is true?
A. The diagram must have firms on the left side.
B. Firms purchase final goods from households in return
for cash.
C. Households pay rent and interest to businesses in
return for use of factors of production.
D. Firms pay wages to households in return for labor.
E. The money relationship between labor and firms
exists only in a command economy.
#13. On a simple circular flow diagram with boxes only
for households and firms includes
which of the following?
I. Households buy factor services from firms
II. Households buy outputs from firms
III. Firms sell factor services to households
IV. Households sell outputs to firms
A. I and II
B. I and III
C. II
D. III and IV
E. IV
#14. Using a circular flow model,
which of the following is true?
A. Firms are suppliers in the factor markets.
B. Firms are demanders in the product markets.
C. Households are demanders in both the product
and factor markets.
D. Households are demanders in the product markets
and suppliers in the factor markets.
E. The government is a supplier in the product
market only.
#15. Which of the following is an injection into the
circular flow diagram?
A. Investment spending
B. Taxes
C. Government borrowing
D. Investment borrowing
E. Savings
#16. Why aren’t transfer payments included in the
calculation of gross domestic product?
A. Transfer payments are used to pay for intermediate
goods which are excluded form GDP
B. Transfer payments are part of government
spending, and GS is not included in GDP
C. It would lead to double counting
D. Recipients of transfer payments are usually
children, and they are excluded from GDP
E. Recipients of transfer payments may not be US
citizens.
#17. Which of the following represents a leakage from
the circular flow in an economy?
(A) Social Security payments
(B) Government borrowing
(C) Investment spending
(D) Consumption
(E) Imports
#18. In the circular flow diagram, which of the
following supplies the factors
of production?
(A) The Product Market
(B) Government
(C) Households
(D) Financial sector
(E) The foreign markets
Answers:
#12 D
#13 C
#14 D
#15 A
#16 C
#17 E
#18 C
I sure hope that is everything.
On my CD there are two practice Circular Flow
Diagrams that test your understanding of the
concept. (mod 10)
Also for mod 10, there is a reading about how
GIX = STM determines the federal budget
situation. (Budget Deficit as an Accounting
Identity)
As always,
Good bye and Good luck,
Wayne iNWI