Download 17. Circular Flow

Economics
What You Need to Know
Chapter 17
Circular Flow
17.1 WHY AGGREGATE?
My boss, not an economist, was sometimes confused about the macroeconomic
interrelationships and connections of sectors within the economy. It seemed like
he could not visualize the entire macroeconomic picture, and he did not fully
understand its relevance to the business firm of which we were employed. I had
an idea how to help him, and we called it MMM – mental macro model. A cute
name, but its roots were the principles of circular flow that you are about to
discover in this chapter.
The next few pages describe the basic ebb and flow of economic activity
and how different parts of the economy are interconnected.
We will build a
framework of analysis in this chapter. We will model income, expenditures and
the economic activity within various sectors. In the next chapter, we will define
ways to measure the economy, and in a subsequent chapter, we will learn how
to predict short-range events. Our analysis will rely upon economic indicators
collected by the government. Therefore, we must at least recognize both the
value and deficiency of aggregate data. An old joke among economists is that
economic indicators are like sausage. They taste real good but you don’t want
to know what they are made of. Although government statistics will help us
discern events, we should recognize the difficulty of measuring America’s
elaborate economy. The economy is large and data collection methods are not
perfect.
Despite the imperfections of macro analysis, government statistics
provide a sufficient perspective on fluctuations in government economic activity
when coupled with a conceptual framework of the economy.
To begin the
analysis, five sectors of the economy are designated.
They include
1) households, 2) business firms, 3) financial intermediaries, 4) government, and
5) the rest of the world. By examining the economy’s different sectors, we will
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achieve a clearer understanding of their interrelationship, measures of the
current state of the economy, and predictors of the economy’s future.
Key Point: A conceptual framework of macroeconomic activity among various
sectors is what you need to know.
17.2 WHAT IS CIRCULAR FLOW?
Macroeconomic activity is understood using a simple conceptual framework
called circular flow. (See Exhibit 17-A.) The model starts with two sectors, firms
and households. Firms are producers of goods and services, while households
are people supplying labor and other resources to the firms. If households did
not supply resources to firms, then the firms would not be able to supply output
to the households.
The circular flow exists because households supply the
resources that produce the output for households.
While production has a circular flow, a monetary flow circulates in the
opposite direction.
Because households demand output, firms produce the
goods and services. Because firms demand resources, households provide their
labor and other resources. A monetary circular flow occurs because money flows
from households to firms for output demanded. This part of the circular flow is
called expenditures, E. In turn, the interchanging money flows to households to
pay for the resources. This part of the flow is called income, Y, which is identical
in amount to expenditures per the expression below:
Y = E
As an identity, circular flow teaches that income is equivalent to
expenditures. This must be true because the income received from producing
goods and services is spent on the very same output. For example, when an
economy produces $10 trillion of output, the $10 trillion of income received by
households for supplying resources is what is used for the expenditures on $10
trillion worth of goods and services that were produced.
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Exhibit 17-A
Circular Flow
$
Expenditures
Output
Households
Firms
Resources
Income
$
Circular flow shows that income equals expenditures.
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If the model of circular flow confuses you, then you are likely forgetting
that circular flow is a model of the whole economy. For example, you might
argue that the firms keep some of the expenditure money as profits and,
therefore, income to households cannot equal expenditures. However, profits
for firms are really just profits for households because people own firms.
Attempting to be lucid, the circular flow framework emphasizes only the primary
elements of macroeconomic activity.
Shortly we will improve the model by recognizing three other important
sectors of the economy.
Even at this stage, the model provides a rich
framework to help us understand critical ideas.
For instance, two types of
markets are seen. First, there is an aggregate market for output, where firms
supply goods and services upon households’ demand.
Second, there is an
aggregate market for resources, where households supply their labor and other
resources upon demand from firms. One market could not exist without the
other market, since they are linked in a circular manner.
markets advance together.
In practice, the
Take the case of expenditures from the output
market increasing rapidly. Since income will equal expenditures, the resource
market will expand as well. An expanding demand for goods and services leads
to an increasing utilization of factors of production.
Therefore, both
expenditures and income grow.
Key Point:
income.
Income is necessary for expenditures, but expenditures create
17.3 WHAT ARE INJECTIONS AND LEAKAGES?
It would appear that circular flow describes a utopian economic system. More
expenditures yield greater income, while more income provides the means for
higher expenditures. Although this basic relationship is correct, circular flow is
interrupted by what economists call leakages. (See Exhibit 17-B.) Like water
spilling from a container, a leakage from circular flow occurs when some of the
income escapes household spending but is collected in another vessel. Some
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Exhibit 17-B
Circular Flow
with Leakages and Injections
Consumption
Households
Firms
Leakages
Savings
Injections
$
Investment
Spending
Government
Purchases
Taxes net
of transfer payments
Exports
Imports
Leakages reduce and injections enhance circular flow.
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household income is voluntarily saved and is a leakage from the circular flow
model. (Typical practice is for households to deposit money in the bank,
although they may elect to purchase more sophisticated financial assets that we
will review in a later chapter.) Furthermore, firms also save by retaining some
profits that otherwise would be distributed as income to households (who are
shareholders).
The amount not saved but spent by households is called
consumption.
Banks and other financial institutions form the other vessel – financial
intermediaries.
It is the third sector of the economy that gathers savings in
order to make loans to firms and others who wish to borrow. If savings cannot
be readily loaned, then the leakage would result in reducing circular flow.
spending causes less income to occur in the economy.
Less
However, with the
assistance of financial intermediaries, markets for loanable funds eventually
adjust to utilize savings.
Most loans are taken by businesses wishing to purchase capital in quest
of greater profits. Borrowing and subsequent purchases of this sort are really
another type of expenditure that economists call investment spending.
(Investment also includes inventory investment and residential investment,
which will be discussed in a subsequent chapter.)
In the context of circular
flow, investment spending represents an injection into the economy.
Like a
running faucet that fills a container, an injection to the circular flow occurs when
savings return as investment spending.
Another leakage occurs from taxation. Unlike savings that are voluntary,
the fourth sector, government, imposes various taxes that reduces income
available for household expenditures. Although most Americans recognize their
civic duty, taxation frustrates their ability to consume or save. However, part of
the taxes is returned in the form of transfer payments to yield disposable income
for the households. The word transfer is an appropriate name. Tax money is
collected from various households and transferred to other households in such
forms as Social Security, welfare, etc.
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Households who pay taxes for transfer payments experience a reduced
ability to consume.
Households that receive transfer payments have an
increased ability to consume. The circular flow model assumes that those who
receive transfer payments add to spending and offset what was taken from
those who paid the taxes for transfer payments. On the aggregate, taxes net of
transfer payments (Tnet) are a leakage to circular flow. Taxes net of transfer
payments allow government to provide national defense, highways, educational
institutions, etc. Spending as such is termed government purchases of goods
and services - an injection to circular flow.
Imports are a leakage from circular flow. When Americans buy from the
fifth sector, the rest of the world, they are not buying domestic products, so
circular flow income is reduced. However, international trade is never unilateral.
Imports tend to facilitate exports in which our trading partners reciprocate.
Exports are an injection to the circular flow that employs resources and creates
income.
Key Point: Savings, taxes net of transfer payments, and imports are leakages,
while investment spending, government purchases and exports are injections to
circular flow.
17.4 DO LEAKAGES EQUAL INJECTIONS?
We have already learned from the basic model of circular flow that the economy
is in a state of equilibrium when expenditures equal income. The more complex
model of circular flow demonstrates that both leakages and injections can occur
consistent with the equilibrium condition.
Leakages have corresponding
injections that keep the model in balance. This may occur when savings (S)
equals investment spending (I), when taxes net of transfer payments (Tnet)
equals government purchases (G), and when imports (M) equal exports (X).
S = I, Tnet = G, and M = X
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Since each corresponding leakage is matched by an equivalent injection, a
general principle is apparent - equilibrium occurs when leakages equal injections.
Summing all the leakages: The economy has S + Tnet + M, and summing all the
injections - the economy has I + G + X. The following equation represents this
observable fact:
S + Tnet + M = I + G + X
With the equation above, we can elaborate on the principle of leakages
equaling injections. The assumption, at this point, is that for each particular
leakage, a corresponding injection of equal value exists.
Illustrating with
fictitious numbers, savings and investment equal $2 trillion, taxes net of transfer
payments and government purchases equal $3 trillion, and imports and exports
equal $1 trillion. Therefore:
$2t + $3t + $1t = $2t + $3t + $1t
Recognize the assumption, a particular leakage will be matched by a
particular injection, is somewhat unsophisticated. For example, the assumption
is that the government achieves a balanced budget – a balance between Tnet
and G – both being equal to $3 trillion. However, political leaders might instead
elect to spend more on government purchases than they have in taxes net of
transfer payments. Tnet may equal $3t, but G instead equals $4t. To finance
the $1 trillion deficit between the two, the government could borrow $1 trillion
from the pool of savings that otherwise would have been fully available for
investment spending by business firms. This implies that investment spending
cannot be as large because of insufficient funding. In this case, investments
spending would be reduced to $1 trillion. The equation above would instead
show this result:
$2t + $3t + $1t = $1t + $4t + $1t
Notice that numbers above are consistent with the principle that leakages equal
injections. Also note that savings of $2 trillion has not changed in the example.
The mix between investment spending and government purchases is different –
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investment spending is $1 trillion and government purchases are $4 trillion. This
illustrates that particular leakages or injections do not have to match, but instead
the aggregate amount of leakages must equal injections as an equilibrium
condition of circular flow.
Key Point: Leakages are equivalent to injections at the aggregate level.
APPENDIX – CHART OF SECTORS, ACTIVITIES, SYMBOLS, EQUATIONS
Sectors
Activities
Households
Consumption (C)
Saving (S)
Firms
Investment (I)
Financial Intermediaries
Creating loanable funds markets
Government
Government Purchases (G)
Taxes net of transfer payments (Tnet)
Rest of the World
Exports (X)
Imports (M)
Income (Y) from resource market = Expenditures (E) from output market
Leakages (S + Tnet + M) = Injections (I + G + X)
The following chapter will show: E = C + I + G + Net X,
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where Net X = (X – M)