The Circular Flow * Extending Micro to Capture Government


The Circular Flow – Extending

Micro to Capture Government

Dr Brian O’ Boyle

Micro foundations

• The cumulative effects of the micro theory of choice are supposedly optimal

• All individuals choose to allocate their own resources optimally.

• If you judge your options and decide to buy or sell this is only because it improves your welfare.

• It follows that markets which maximize trade (at equilibrium) also maximize individual welfare. This is once again achieved through the price mechanism

Micro foundations

• The scarcity which we face is also minimized as we move all goods and services to their optimal ends

• This means there is no waste (max efficiency) no involuntary unemployment and, because of this, no need for government action.

• Government’s can only affect dead weight losses by taking scarce resources needed by individuals and using them in ways that are less optimal.

• The underlying narrative is – who is better at deciding how to use your scarce resources than you?

The Great Depression

• The problem with this model was its inapplicability with reality during the

Great Depression.

• For 10 years the supposed optimality of the free market was refuted in practice.

• Unemployment in USA stood at 25%, output down 40%; Germany 40% unemployment and 60% output gap.

• Growing consensus that the only way to solve this crisis was to engage government


• Keynes captured some of this in his classic text The General Theory of Employment

Interest and Money

• Keynes trained as a neoclassical economist disputes neoclassical theory of factor markets.

• Unemployment could be generated involuntarily for a variety of reasons (1) lack of knowledge, (2) money non-neutrality (3) MEC etc.

• Unlike non-capitalist crises, Keynes believed this was a crisis made by society.

• Not a lack of technological capacity but a problem of social organisation.

• Factories lying idle even though people needed the output and were willing to work

Rising Government

• Different capitalist societies solved the crisis in different ways.

• In Germany the need for strong government was expressed through Fascism

• In the Western World it was expressed through a rise in infrastructure, welfare and warfare spending (New Deal in USA).

• The world crisis was generally resolved through government re-organisation of the economy in the face of war

• This more active role for government also continued after the war ended.

Rising Government

• After WWII the percentage of the economy in public hands increased dramatically (from around 15% to around 35% -in some cases 50%)

• The circular flow model is an attempt to add a view of the macroeconomy onto micro foundations without any contradictions!

• Joan Robinson called the result bastardised Keynesianism – contradictions were not eradicated!

Circular flow

• The model tries to capture aspects of the micro-economy still presumed to be in equilibrium alongside a new role for government

• The question is why do we need the government so?

• This is a great platform for a discussion of the welfare state, the mixed economy the need for fairness etc…….

• Lets have a look at the model itself

Circular Flow

Circular flow

• The flow of income and goods/services captures many of the features captured in micro-supply and demand analysis.

• We still have an equilibrium model in which all of the factors supplied find some firm to demand them and all firms find someone to demand their outputs.

• Now, however, there are potential leakages from the model which allow you to think about a more positive role for government.

Circular Flow

• The economy will be in equilibrium if the total income generated is equal to the total output created. This relies upon the total output being purchased by those with the income (Say’s Law holding)

• This brings the total expenditure into line too.

• Once there is a balance across the three indicators the economy is back in equilibrium.

• Keynes believes for a variety of reasons that expenditure will not be high enough.

Circular Flow

• If the amount of spending is not high enough to buy up all goods and services we will have unsold inventories leading to involuntary unemployment

• The way to solve this is either to use fiscal and monetary policy (demand side) –this was Keynes’s solution

• Alternatively it is so engage in supply side transformations (this is neoliberalism and it is what has been pursued in Ireland

• This allows a discussion on the appropriate role for government

Measuring the Economy

• Once we have given the students the requisite background knowledge about the historical breakdown of capitalism, the inability of neoclassical theory to explain the crisis and the attempts to introduce a more positive role for government you can get down to explain why the government wants to measure the economy

• This is for the obvious reason that if it is going to manage it properly it must have a handle on the various flows of income, expenditure and production relations within the economy.

Measuring the Economy

• Why do we need all three measures?

• Alongside their theoretical function in proving equilibrium - the income, expenditure and output methods each have a role in providing government with information needed in their new role as economic managers.

• The incomes method allows government to understand the distribution of the society’s resources. This helps with any aspiration to redistribute wealth in the interests of either fairness or efficiency (Keynes and need for effective demand).

Measuring the Economy

• The Expenditure method is very important when working out the balance of expenditure inside your economy.

• In most developed western economies the proportion of expenditure of C

(consumers spending) is around 60-70% with investment around 15-25%

• In China the investment figure is more like 50% indicating a lack of middle class expenditure within the economy (China is currently trying to rebalance its economy). This can lead to economic crises.

Measuring the Economy

• Finally there is the output method – this is crucial for allowing governments to see the infrastructural and human capital needs of the wider economy.

• If the economy is producing a certain number of pharmaceutical goods, agricultural goods and IT, it may need a level of water, electricity capacity that needs to be planned for etc.

• Measuring the economy pioneered in the early 1930’s and generalised in the 1950’s.

• Simon Kuznets at the National Bureau of Economic Research in USA was an innovator on national income statistics.


• Teaching macro as an uneasy extension of micro allows the space to challenge ideas and to think about the great minds that coped with the last

Great Depression.

• It also allows students to see the contested nature of economic ideas (I think this is extremely important).

• It also opens up new vistas in terms of real world analysis.

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