Download SPECIAL TOPIC: Building a Circular Flow Diagram McCaffery © F

SPECIAL TOPIC: Building a Circular Flow Diagram
McCaffery © F.10, F12
This is where I start with the students. They need a full half sheet of note paper.
This first Circular Flow diagram will show both where the dollars are flowing and the goods, services, and
factors flowing in return for the payment of money.
Money flows to firms
Product Market
AD AS
Money flows to purchase G & S
Goods & S flow into HH
Goods & Services
Sent to
Market
Firms, purchase
for resale
Households,
purchase for final
consumption
Factors of Production
Flow into firms
Payments
For
Factors of
Production
Factor Market
D
S labor
HH offer F of P to Firms
Income received for F of P
This is crude, but I start by putting the four boxes up, labeling and defining them. HH are where Goods and
Services (G & S) are purchased for final consumption. Firms are where Factors of Production (F of P) are
purchased to be resold later. The Factor Market is a combination of many markets, we most often talk about the
market in Labor. It could be lumber, meat, or land. And the Product Market is where all finished goods and
services available for sale are found. Prices for all sorts of items are established in MARKETS.
Start anywhere you like, I like starting with Households (HH) making a purchase. They want a high chair. No
idea where to find one, never bought one before, but they just know it is out there on the Product Market. After
shopping around they make the purchase, hand over money, and walk away with the high chair.
The money flows to the manufacturer who now finds their inventory (a key economic measure) of high chairs is
low so they order a new one made. To do so they have to hire labor, purchase lumber and glue on the Factor
Market. They pay money for these items and that money flows to the HHs who supplied the items. A key
assumption here is that ultimately HHs own the Factors of Production and all payments for such flow to them.
The money goes round and round. In this model no money leaks out.
Once students have absorbed this it is time to move on to a more complicated Circular Flow Model. In this case
I tell students they will need at least a full page for the drawing. Start by having them put the four boxes in
similar positions but stretched out as much as they can, but saving as bit of room in the upper right hand. HH to
the far right and Firms to the far left. Product Market at the top of their sheet and Factor Market at least 80%
down the sheet. In this model we will only follow the money. Money is how we measure many activities in
economics, but students should keep in mind that it is what flows in the other direction which is important.
Product Market
NP
Consumption
Draw with substantial gaps here
NP
Firms
Households
A few new names, and a special Consumption arrow which is open
to allow other flows to join it.
NI
Factor
Payments
WPIR
Factor Market
NI
National Income is composed of
Wages, or compensation for working
Profits from business
Interest and dividends
Rents
NP
PRODUCT
MARKET
AD/AS
Consumption
NP
Investment Expenditures
FIRMS
HOUSEHOLDS
Investment
Borrowing
net
savings
FINANCIAL
MARKET
NI
S & D loanable funds
Factor
Payments
WPIR
FACTOR
MARKET
Labor market S&D
NI
Here we introduce
#1. The Financial markets, where all saving and borrowing takes place. The Loanable Funds Market would be
found here.
#2. Households save in a typical year. This is labeled NET savings, because Households are saving and
borrowing. Usually, HH save more than they borrow, so the net savings is a positive going into the FM. We
might think that some HHs save and others Borrow, but the same HH can being both at the same time, saving
for retirement and borrowing for a car.
#3. In a balanced economy, Firms’ borrowing equals HHs’ savings. Some Investing may be planned, others
unplanned. There of course is the expansion of the manufacturing plant, but there is also investment in
Inventories, and that is where Unplanned Inventory changes lead to the unplanned investment. So no money is
lost or leaked away permanently. The Leakage from households to the Financial Markets is, at this time in he
drawing equal to the injection from Investment Expenditures.
Does this look like a circular flow or a pile of intestines?
NP
PRODUCT
MARKET
Consumption
NP
Investment Expenditures
GOVERNMENT
FIRMS
government
purchases
HOUSEHOLDS
Net Taxes
Investment
Borrowing
government
borrowing
net
savings
NI
FINANCIAL
MARKET
Factor
Payments
WPIR
FACTOR
MARKET
NI
Now we have added Government, all levels of government. Typically about 30% of the economy. Start with
the box, government. We pay taxes and at the same time many households receive Transfer Payments from the
government. We pay more in than comes back as Transfers (Social Security, scholarships, food stamps,
unemployment compensation, etc. Transfers is a really nice word, so new it is hard for students to have
negative connotations associated with it. ) so the arrow is NET taxes paid in. The government takes that
amount and most often uses more than they received as taxes so they must go to the Financial Market to borrow
the difference, hence Government Borrowing
Now is a good time to say that all money going into a box MUST come back out of the box or the Circular Flow
has a stroke, crashes and burns. HH savings of $7 could be broken into $4 going to Firms and $3 going to
government. Net Taxes are a leakage away from the main circular flow and Government purchases is an
injection of money back into the main circular flow.
FOREIGN
ECONOMIES
NP
PRODUCT
MARKET
X
M
ForEx Market
Consumption
NP
Investment Expenditures
GOVERNMENT
FIRMS
government
purchases
HHs
Net Taxes
Investment
Borrowing
government
borrowing
net
savings
NI
FINANCIAL
MARKET
Factor
Payments
WPIR
FACTOR
MARKET
NI
Capital
Inflows
Finally, the International Markets. When HHs or Firms or Government purchase a Good or Service from
outside the US it is a leakage, as money flows out of the main circular flow, this is called an Import. While the
car may come here from Japan, the money flows to Japan. Again, the money is how we keep track of things,
but the unshown arrows going in the opposite direction would hold what was received for the money is the
ACTUALLY the important consideration. At the same time, foreign entities buy US made goods and services
which we call Exports. And the money for those exports flow into the US’s Circular Flow as an Injection.
As long as X = M the Capital Inflows arrow is unnecessary. But they seldom do equal each other. The
difference is found in the Capital Inflows arrow. If we purchase $7 of Imports from foreign economies and they
only use $3 of those dollars to buy our Goods and Services, our exports, then they are left with $4 of US
currency which can’t be used in their economy. So they use it to purchase a savings device from our Financial
Markets. China, Japan, and Canada use much of their imbalance to purchase US government bonds. IF X > M
then we would have money flowing in this arrow towards the foreign economies, a negative Capital Inflow.
We end up with 7 boxes, and 13 arrows. NOW WHAT CAN WE DO WITH THEM? See the Notes for
Module 10 and 11.