Chapter 3
The American
Economy in a
Global Setting
“What Goes Around Comes Around”
• When firms prosper, so do households.
When households struggle, so do firms.
• What are the economic forces that
connect the well-being of households
and firms?
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Chapter Objectives
• After studying chapter 3, you will know:

How households and firms are connected
by a circular flow of economic activity

How the product and resource markets
connect households and firms

What role the government plays in
the economy
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Chapter Objectives (cont’d)

What role financial markets play in
the economy

How imports and exports affect the circular
flow of economic activity
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The Circular Flow of Economic Activity
• Households and firms interact so closely
that the well-being of one depends on the
well-being of the other.
• This interaction is represented by the circular
flow model.
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Figure 3.1
The Circular Flow of Economic Activity
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Households and Firms:
The Product Market
• Households purchase goods and services
from firms in product markets.

Spending flows from households to firms.
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Households
• Characteristics:

One-fourth are headed by single
individuals.

About half are headed by two parents.

They are aging.

They are geographically mobile.
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Firms
• Firms take on many different forms:

Sole Proprietorships
• Only one owner

Partnerships
• Several owners pool their resources.

Corporations
• Sell ownership in the form of stock
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Figure 3.2 The Changing Pattern in U.S.
Production Between 1947 and 2004
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Changes in the U.S. Economy
• Major trends:

The emergence of the service sector
• Between 1947 and 2003 there has been
explosive growth in:




Legal services
Health services
Social services
Firm to firm transactions
• Represent 14% of purchases in
product markets
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Households and Firms:
The Resource Market
• Firms hire factors of production from
households in resource markets.

Income flows from firms to households.
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Exchange in the Resource Market
• Income takes the form of payments to:

Labor, which earns wages, salaries, and
other compensation

Landowners, who earn rent

Capital, which earns interest

Entrepreneurial skill, which earns profit
• Proprietor's income and corporate profits
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Figure 3.3 Sources of Income
in the United States Economy in 2004
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Using the Circular Flow
• The circular flow model provides
important insight into the economy and
public policy.

Households and firms—and their economic
health—are linked together by flows of
spending and income.
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The Government Sector of the Economy
• The government also affects the circular flow
of economic activity.

Direct effects:
• Adding to or taking from the flow of income

Indirect effects:
• Purchasing goods and resources in markets
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Levels of Government and the
Circular Flow
• Local Government


Collects property taxes
Provides parks, museums, schools, police protection
• State Government


Collects sales taxes
Provides roads and school systems
• Federal Government



Collects income taxes
Pays transfer payments
Provides national defense and interstate highways
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Government Spending, Government
Revenue, and the Circular Flow
• Government adds to incomes by providing
transfer payments.

A shift of funds from one group to another

Do not involve exchange or transactions

An injection into the circular flow
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Government Spending, Government
Revenue, and the Circular Flow (cont’d)
• The government takes away from the flow of
income through taxes.

A leakage from the circular flow
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Government Spending, Government
Revenue, and the Circular Flow (cont’d)
• Government spending refers to the
government’s transactions in product and
resource markets.
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Spending, Taxes, and the Budget Deficit
• A federal budget deficit occurs when the
government spends more money than it
takes in.

Financed by selling securities
• Conversely, a federal budget surplus
occurs when tax revenues exceed
government spending.
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The Financial Sector
• Households also save some of
their income.

A leakage from the circular flow
• Firms require funds to buy capital.
• The financial sector brings savers and
borrowers together to recycle funds into
the economy.
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The International Sector of the Economy
• Up to this point, we have looked at a
closed economy.

Based on the assumption that households and
firms don’t engage in international trade
• An open economy is an economy that does
engage in international trade.
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Trade and the Circular Flow
• Imports are goods that are purchased
from foreign producers.

A leakage from the circular flow.
• Exports are goods that are produced
domestically and sold to foreign buyers.

An injection into the circular flow.
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Trade and the Circular Flow (cont’d)
• The difference between exports and
imports is called net exports.

Trade Surplus

Trade Deficit
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Table 3.1 U.S. Exports and Imports in 2004 by
Product Group (in Billions of Dollars)
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Life Lessons
• No economy is an island.

The well-being of nations is closely linked
through the international sector of each
nation's economy.
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Strategy and Policy
• Unexpected Victims of Taxation

Who could complain about taxing the yacht
industry, an industry that caters to the rich
and powerful?

Many unskilled workers lost their jobs!
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Summary
• The Circular Flow of Economic Activity

Income cycles from households to firms and
back again.
• Households and Firms: The Product Market

Households exchange money for goods and
services from firms.
• Households and Firms: The Resource Market

Firms pay income to households in exchange for
factors of production.
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Summary (cont’d)
• The Government Sector of the Economy

Governments enter the flow through taxes
and spending.
• The Financial Sector of the Economy

The financial sector connects savers
and borrowers.
• The International Sector of the Economy

Imports are a leakage while exports are
an injection.
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