THE MACROECONOMIC
CIRCULAR FLOW
PART II
We will now add the Business Sector to the model.
We can do this by including the Business Sector in
the same icon we used for Households.
Households
Businesses
PRODUCT
MARKET
I
N
C
O
M
E
P
R
O
F
I
T
SPENDING (GDP)
By simplifying, we can split total
income into two broad streams.
W
A
G
E
S
Households
Businesses
Income to Households we’ll call
“Wages.”
Income to Business we’ll call
“Profit.”
PRODUCT
MARKET
SPENDING
I
N
C
O
M
E
P
R
O
F
I
T
W
A
G
E
S
Households
Current Domestic
Spending
Uses of Income
Businesses Uses of Income
We could continue
to keep the
business and the
household
sectors separate,
but it turns out:
1. this isn’t terribly
helpful for our
purposes, and
2. It makes the
diagram pretty
messy
PRODUCT
MARKET
I
N
C
O
M
E
DOMESTIC
PRIVATE
SECTOR
SPENDING
C
O
D
N
O
S
M
U
E
M
S
P
T
T
I
I
C
O
N
SO LET’S SIMPLIFY
1. Don’t Separate Income
into Profit and Wages
2. Combine Households and
Businesses into the Domestic
Private Sector
3. Combine the spending streams
of Households and Businesses –
call it Consumption
4. Combine all the other uses
of Households and Businesses
income.
Other Uses of Income
PRODUCT
MARKET
I
N
C
O
M
E
DOMESTIC
PRIVATE
SECTOR
SPENDING
C
O
D
N
O
S
M
U
E
M
S
P
T
T
I
I
C
O
N
So ... what are the
other uses of income
Remember ...Each of these is
the combination of income used
by Households and by
Businesses
I
M
P
O
R
T
S
S
A
V
I
N
G
Other Uses of Income
T
A
X
E
S
PRODUCT
MARKET
I
N
C
O
M
E
DOMESTIC
PRIVATE
SECTOR
SPENDING
C
O
D
N
O
S
M
U
E
M
S
P
T
T
I
I
C
O
N
INCOME
E
X
P
O
R
T
S
I
N
V
E
S
T
M
E
N
T
I
M
P
O
R
T
S
S
A
V
I
N
G
We can
add back
the three
other
types of
spending
G
O
V
T
T
A
X
E
S
PRODUCT
MARKET
I
N
C
O
M
E
DOMESTIC
PRIVATE
SECTOR
INJECTIONS
C
O
D
N
O
S
M
U
E
M
S
P
T
T
I
I
C
O
N
E
X
P
O
R
T
S
INJECTIONS -the sum of
Exports,
Investment and
Government
Purchases
I
N
V
E
S
T
M
E
N
T
G
O
V
T
P
U
R
C
H
A
S
E
S
TWO MORE TERMS
I
M
P
O
R
T
S
LEAKAGES -the sum of
Imports,
Saving and
Taxes
LEAKAGES
S
A
V
I
N
G
T
A
X
E
S
PRODUCT
MARKET
I
N
C
O
M
E
HOUSEHOLDS
And
BUSINESSES
INJECTIONS
C
O
D
N
O
S
M
U
E
M
S
P
T
T
I
I
C
O
N
E
X
P
O
R
T
S
I
M
P
O
R
T
S
INJECTIONS –
appear to come
“from nowhere.”
LEAKAGES –
appear to go
“to nowhere.”
LEAKAGES
I
N
V
E
S
T
M
E
N
T
S
A
V
I
N
G
G
O
V
T
P
U
R
C
H
A
S
E
S
T
A
X
E
S
PRODUCT
MARKET
I
N
C
O
M
E
HOUSEHOLDS
And
BUSINESSES
INJECTIONS
E
X
P
O
R
T
S
I
N
V
E
S
T
M
E
N
T
S
G
P
U
R
C
H
A
S
E
S
G
C
O
O
D
V
N
T
O
S
M
U
E
M Because spending and income can come from and
S
P go to “nowhere” we call this the OPEN MODEL
T
T
I
S
I
T
M
I
A
A
P
C
V
O
X
O
I
E
R
N
N
S
T
LEAKAGES
Again, let’s simplifying the diagram for drawing purposes.
Here’s one version --
PrM
X
Injections
E
I
G
F
S
T
C
H/B
Y
Leakages
Here’s another simplified version --
PrM
X
Injections = E + I + G
C
H/B
Y
Leakages + F + S + T
INCOME CAN BE EXPRESSED IN TWO WAYS
1. Where does it come from -Income = Wages + Profits
=
from “working” + from “owning”
2. Where does it go -Income = Consumption + Leakages
= back to the Product Market (Consumption)
+ to “somewhere else (Leakages)
SPENDING CAN BE BROKEN INTO TWO TYPES
Spending = Consumption + Injections
= from Income + from somewhere else
THE CLOSED MODEL
and
MARKETS
A somewhat different view from the
open model stresses the idea that income
does not escape from the economy, but
instead is kept circulating within the
economy.
There are four
macroeconomic markets
1. The Product Market –
where goods and services are
produced and sold.
3. The Credit Market –
where people with money to
lend contact people who
want to borrow: banks, the
stock market, credit unions,
etc.
2. The Labor Market –
where workers are hired
4. The Foreign Exchange
Market –
where the currencies of
different countries are
exchanged in order to to
make trade possible. Think
of the Foreign Exchange
Market as the way we talk to
the rest of the world.
PRODUCT
MARKET
SPENDING (X)
The PRODUCT MARKET
refers to all the stores and
factories in the economy.
Money enters the market as
spending and is paid out as
income to Households and
Businesses.
INCOME
(Y)
CONSUMPTION
(C)
Households
And
Businesses
INCOME (Y)
Most Income is then sent
back to the Product Market
as Consumption.
PRODUCT
MARKET
SPENDING (X)
INCOME
LABOR
MARKET
WAGES
C
The LABOR MARKET
splits total Income into two
parts: Wages, going mainly
to Households, and Profits,
going to Businesses and
their owners.
PROFIT
Households
And
Businesses
INCOME (Y)
PRODUCT
MARKET
H/B
SPENDING (X)
INVESTMENT
(I)
The part of
income that is
not spent (that is
The CREDIT
saved) goes in
MARKET
C
CREDIT
to the Credit
exists to link
MARKET
Market (banks
savings and
and other saving
investment.
institutions).
Savings
Businesses
(S)
borrow from
there to invest
(buy capital).
INCOME (Y)
PrM
SPENDING
(X)
C
Exports
(E)
Dollars return to the
US when other
countries pay for our
Exports.
FxM
The FOREIGN EXCHANGE
MARKET exists to allow
trade between countries
with different currencies.
Imports
(F)
H/B
INCOME
(Y)
Dollars leave the US
to pay for our Imports
from other countries.
PrM
SPENDING
(X)
C
H/B
The TREASURY is
the part of the
government
whose job is
(among other
things) to collect
taxes, pay for
government
purchases and
borrow money to
fund the
government.
INCOME
(Y)
Gov’t Purchases are
part of spending
Gov’t
Purchases
(G)
Budget
Balance
(BB)
The Budget
Balance usually
refers to the
“Budget Deficit,”
the amount the
gov’t has to
borrow per year.
TRSY
Taxes
(T)
Taxes are taken
from Income
But we need to add two
more important flows
of credit
THIS MODEL
IS CLOSED
PrM
X
C
H/B
Y
E
I
G
FxM
CrM
TRSY
F
S
T
1. THE BUDGET BALANCE (BB)
A budget deficit occurs if the government
spends more than it takes in as taxes.
The government must then borrow this
amount.
Money goes from the Credit Market into the
government Treasury.
A budget surplus occurs if the government
spends less than it takes in as taxes.
The government can then lend this amount.
Money goes from the Treasury into the Credit
Market.
The Budget Balance
in
THE CLOSED MODEL
PrM
X
C
H/B
A Budget Deficit (when
Purchases exceed Taxes)
goes from the Credit
Market to the Treasury.
Y
E
I
The Gov’t
Budget Balance
G
FxM
CrM
BB
TRSY
F
S
T
A Budget Surplus (when
Taxes exceed Purchases)
goes from the Treasury to
the Credit Market.
2. Foreign Capital Flows (K)
A Foreign Capital inflow (Kin) occurs when the US
borrows dollars from the rest of the world.
This happens when rest of the world has an excess of
dollars.
This is the case when the US imports more than it
exports.
A Foreign Capital outflow (Kout) occurs when the US
lends dollars to the rest of the world.
This happens when the rest of the world is short of
dollars.
This is the case when the US imports less than it
exports.
Foreign Capital Flows
in
THE CLOSED MODEL
PrM
A foreign capital outflow goes
from the US credit market to
the rest of the world, through
the Foreign Exchange Market
X
E
C
FxM
Foreign
capital can
be either an
inflow or an
outflow
K
F
H/B
A foreign capital inflow goes
from
Y the rest of the world,
through the Foreign Exchange
Market, to the US Credit Market.
I
G
CrM
TRSY
S
T
Putting this all together we have the
CLOSED MODEL
THE CLOSED MODEL
PrM
X
E
C
FxM
F
H/B
Y
I
K
CrM
S
G
BB
TRSY
T
Only two more pieces to go.
1. The Money Supply and The Federal Reserve.
The Federal Reserve (known as “The Fed”) is the
government agency whose job it is to control the
quantity of money and credit available in the
economy.
We will picture them as a part of the Credit Market,
able to add or take money from the banking system.
THE FEDERAL RESERVE and the
MONEY SUPPLY
PrM
X
I
C
CrM
To keep things simple we’ll
ignore the Foreign Sector
and the Treasury
This shows an increase
of the money supply.
Newly printed money
comes out of the Fed
and in to the Credit
Market
ΔMS
S
The FED
H/B
Y
THE FEDERAL RESERVE and the
MONEY SUPPLY
PrM
X
I
C
This shows a decrease
of the money supply.
The Fed takes money
out of circulation.
CrM
ΔMS
S
The FED
H/B
Y
2. Money Demand, Liquidity and the Velocity of Money.
The last component of the model is the public’s desire to hold money
– to be liquid – as opposed to lending money. This is represented by
the “Cash Box.”
How much money the public (including banks) wants to hold is
related to the question of how quickly money moves through the
economy, how fast a dollar goes around the circular flow diagram.
This concept is called the velocity of money
Money coming out the Cash Box represents:
a. an decrease of the demand for money (people are holding less)
b. an increase of the velocity of money (money is moving faster)
Money going into the Cash Box represents:
a. an increase of the demand for money (people are holding more)
b. a decrease of the velocity of money (money is moving slower)
THE CASH BOX and MONEY DEMAND
PrM
X
I
C
CrM
ΔMD
Cash
H/B
Y
S
This shows a decrease
of the money demand.
The public holding less
money. The velocity of
money is rising.
THE CASH BOX and MONEY DEMAND
PrM
X
I
C
CrM
ΔMD
Cash
H/B
Y
S
This shows a increase
of the money demand.
The public is holding
more liquidity. The
velocity of money is
falling.
Once you add the Money Supply and Money
Demand into the model, the terminology of “open”
and “closed” model doesn’t apply.
So we now have three classes of Models
1. Open
2. Closed
3. Money
You can imagine any of these being models
as being built up from a set of components.
1.Basic – this includes Income, Spending, Consumption, Saving and
Investment. These variables appears in every model.
2. The Treasury – this adds Taxes, Government Purchases and the
Budget Balance.
3. The Foreign Sector – this adds Imports, Exports and Foreign Capital
Flows.
4. The Money Supply – this adds the Federal Reserve.
5. Money Demand – this adds Liquidity and the Velocity of Money.
REMEMBER THE RULE.
The simplest model that works is the best one to use.
THE END ... for now