Unit 2: Circular Flow

Understanding the Circular Flow and Basic Macro Concepts

We are really just starting on our path to analyzing and understanding the macroeconomy. But economies are really, really complex things.  Just think about the U.S.  Even if we ignore the rest of the world, there are over 310 million different people and nearly 1 trillion different businesses or firms.  They are all making economic decisions. Those decisions affect everybody else’s choices and decisions. Together with governments these decisions constitute the “macroeconomy”.   It’s a lot to figure out.  We have to find  a way to simplify it so we can think about it clearly.  That’s what this unit is about.

In this unit of the course we are going to look at a model or diagram of how the economy is structured.  We will be introducing some terminology.  We need to look at the big picture: the overall structure of the economy and economic activity.  We model that structure in a diagram we call the Circular flow.

IMPORTANT:

This unit, really understanding the circular flow and the terminology that describes different sets of transactions (such as “consumption” or “investment”) is REALLY important for the rest of the course.  Indeed, you’ll find the rest of the course much more difficult if you don’t seriously absorb and learn this unit.

 

Most textbooks (including yours) do a very poor job of explaining or diagramming the circular flow.  It is VERY important that you pay close attention to the tutorial explanation of Circular Flow that I’ve created and placed under the Closer Look link for this unit.  There’s also a printable diagram of the Circular Flow in the Closer Look page.  I recommend printing it and keeping it handy as you read and study the rest of the course.

 

Structure of An Economy

Although the reality of the Economic Problem means that we can never have everything we want, we can get more in the future if things go right. But getting more in the future, what we call economic growth, isn’t even a given.  Sometimes a macro-economy will actually “shrink” or decline.  In other words, people in the economy actually begin producing fewer goods and services than they had been.  Obviously, with fewer goods, standards of living must decline.  At other times, economies grow wildly.  The periods when an economy declines are generally known these days as “depressions” or “recessions”.  Wild growth is usually called a “boom”. This extreme variability in the performance of an economy poses a significant challenge for macroeconomists.  For example, what do we mean by “make the economy better”? How would we know if we made the economy better? Just what does “better” mean? What do we mean by “richer”? And, how do countries get “rich” in the first place.

Macro-economists analyze the performance and structure of a macro-economy by looking at the flow of transactions that occur.  In general, transactions occur in markets and represent the sale/purchase of economic “value”.  We aggregate these transactions to measure the amount of value that is changing hands in the markets.  Aggregating simply means “summing up all the monetary amounts from all transactions”.

In an economy made up of markets, there are three types of markets:  goods (also called product), resource (primarily labor), and financial markets.  These markets and the buying/selling that happens in them create a kind of circular flow of goods and services.  Households (people like you and I) buy goods in the goods market so that we can live and enjoy life.  The goods we buy were produced and sold by firms (businesses).  The businesses were able to produce the goods for us because the firms bought the use of economic resources (land, labor, capital) from households that own those resources in the resource markets.  Thus there is a circular flow set-up:  we spend money in goods markets –> the money firms receive from selling the goods is used by the firms to pay for resources –> the money firms pay in resource markets is our household income (labor, rent, profits) and provides the  money for us to spend in the goods market.

Most macro-economic issues can be analyzed as disruptions or changes in this circular flow of goods, services, resources, and money.

National Income Accounting Concepts

Circular Flow of Goods

Most of the important concepts regarding National Income Accounting can be placed into the circular flow diagram. This section sometimes goes a little over the top in detail and jargon. Try to get an intuitive feel for the big-picture of the circular flow of goods and services.

To better understand the circular flow diagram and much of the terminology that goes with it, it’s important to distinguish between measures that are “stocks” vs. “flows”. If you’ve ever had an accounting course, the idea is very familiar: income statements measure flows, balance statements measure stocks.

Flow and Stock Variables

Distinguishing between flows and stocks is very important in macro. Our primary focus is usually on flow variables, things like “how much money we spent” or “total taxes collected”.  But stock variables are important also. Usually, flow variables relate to stock variables by being the “change in the stock variable”. For example: my wealth is stock variable. It’s the value of everything I own at a particular time. My net income is a flow variable. It’s the amount of money I take in during a period of time. I could also describe my net income as the increase in my wealth during a period of time.  Most of the items discussed in National Income Accounting are “flows”: that is, they are counts or measures of how much money changed hands during a period of time in return for the sale of goods, services, resources, or use of resources.

There are, however, some related concepts that are actually “stocks”. [note that this is “stocks” as in a “stockpile” of something, NOT as in “common stocks” sold on the New York Stock Exchange]. For example, the capital account when discussing international relationships deals with changes in our ownership of foreign assets or investments. Such assets are “stocks”. The change in ownership is a “flow”. Similarly, inventory is a “stock”, but the change in inventories is a “flow”.

If you have a credit card account or a checking account, you should be able to recognize the difference between stocks and flows. Your balance on any particular date is a “stock” measure. How much you charge, or spend, or deposit during the month is a “flow” measure. Flows change stocks.

GDP: The Key Measure

GDP – It’s important to think of GDP as a measure of the value of everything produced. Since we have to produce before we consume, it’s also a measure of what’s available to society to consume. More GDP –> more stuff –> better living.

How can we (or any society) measure how well they are doing in addressing the “economic problem”?  Since the problem arises from scarce resources, we can alleviate the problem by using those resources wisely to produce goods that we want. The more goods produced, the more wants that satisfied. It would seem that all we have to do is count how many goods we produce. In microeconomics we use “quantity” of a good, physical count,  as a measure all the time. Macroeconomics has a bigger problem. How do you count multiple different types of goods. In other words, how do we add apples and oranges? Should we measure production as “units of fruit”? If so, then how do we add in the production of a car? a house? a jet airliner? watching a movie?

This issue of how to measure what we, as a society, produce each year (or each month) is such an important topic that we will look much closer at it in the next unit of this course. Here we introduce the concepts of “Gross Domestic Product” (GDP) and “National Income” (GDI – Gross Domestic Income). Both are measures of how much was produced each year – they are simply calculated from different material, but they usually come to the same answer. GDP measures the dollar value of everything produced and sold for final usage (no further processing) in the goods market.  The GDI, or National Income, measures the total amount we all got paid for producing those goods and services, including profits earned.

In this chapter there are a lot of definitions of measures, and a lot quasi-accounting jargon. Don’t get distracted by the details. There are only three really important equations. If you learn what the symbols or notation mean, they’re fairly easy. Two of these equations appear here and define important relationships.

C + I + G + (X – M) = Aggregate expenditure = GDP

and

Aggregate expenditure = GDP = Aggregate income.

GDP is the total value (in $) of everything they produce and sell each year. Since everything that is sold is also being bought at the same time, GDP is the same as the total spending, or Aggregate Expenditures, for the economy. This total spending is broken down into four categories or types of spending, depending upon who is doing the spending and why. The four types of spenders are consumers (C for Consumption Spending), businesses investing new capital (I for Investment), governments spending on all kinds of things (G for Government spending), and whatever the rest of the world buys from us (called Net Exports). Since we also buy from the rest of the world, we measure Net Exports as (X-M) where X stands for total eXports and M stands for total iMports. (we use X and M as notation since economists already have other meanings for e and i). Count what everybody buys and you get Aggregate Expenditure. Since we had to produce it to be able to buy it, Aggregate Expenditure must be equal to total production, which is what GDP is.

Where do we get the money to spend on buying the GDP? The answer is – GDP itself. While “we” spent the money on GDP, we were also paying that money to “ourselves”. We produced it. We sold it. And we bought it. So we sold it to ourselves. So the total value of what we produced and sold (GDP) is also the total value of what our income was. After all, we earned the income by producing and selling the goods. This total income is called Aggregate Income (Aggregate Income is essentially the same as National Income or Gross Domestic Income. There are differences, but they are insignificant for this course). The Aggregate Income is divided into to two parts, according to who gets to spend the income. “DI” stands for “Disposable Income” – it’s the total income that households (you and I) have available to spend. “NT” stands for “Net Taxes” – it’s the income that the government gets to decide how to spend because they’ve taxed it away from us.

Finally, the last major issue gets us back to the issue of “apples and oranges”. We solve the problem, of course, by not counting units of goods at all, but instead we count the dollar-value that the goods sell for. So GDP depends on both the amount of physical goods produced AND the prices we put on those goods. If we’re going to make comparisons over time, though, this creates a problem. What if all prices go up? Suppose we have 10% inflation and every price of every good increases by 10%. Then the value of GDP would also go up 10%. Would we be 10% better off? No. We would have the same stuff, we would just be using bigger numbers. We solve this next problem by trying to measure how much prices (in general) went up.. To do this, we need to calculate a “Price Index”. We’ll learn more about these price indexes in the units on GDP and Price Stability.

A Note on Notation

There is a lot of notation, abbreviations and symbols introduced in these chapters.  Getting a grip on the notation and the meaning of the terms is very important. These terms and the abbreviations for them are used extensively throughout the course. Here’s a handy guide to the most important ones. This notation is pretty standard throughout the economics profession. Please observe that upper/lower case matters. In macro, most variables use capital letters. If you look closely, you’ll see most of the variables are pretty obvious abbreviations such as “C” for “Consumption spending”. The times they aren’t are when that letter was already used for something else. Then it’s usually the second letter as in “X” for “eXports”.

  • GDP – Gross Domestic Product
  • AE – Aggregate Expenditure (“expenditures” are also called “spending”)
  • AI – Aggregate Income
  • Y – National Income (which is same as Aggregate Income)
  • C – Consumption spending
  • I – business Investment spending
  • G – Government spending
  • X – eXports
  • M – iMports
  • (X-M) – Net Exports
  • DI – Disposable Income
  • NT – Net Taxes
  • S – Savings

Limitations of National Income Accounting

Given that GDP is counting the value of all goods produced-and-sold, at the prices they are sold, it has some limitations. When you really get to it, GDP isn’t a very good measure of well-being. It’s only a rough estimate of market-oriented behavior.  But, it’s all we have – and we didn’t even have this before 1920! Before 1920 we had a conception of GDP but no regular statistics were collected or reported. Economists are always trying to improve the measurement of macro- well-being, but it’s a tough problem.

Looking Forward

We now have some idea of how we can discuss and analyze the activity of an economy at an aggregated level and of what the goals of an macro-economic system are.

In the last unit, we established that we have the following four goals. We also have some statistical measures that we can use to get some sense of how well the economy is performing.

  • Growth: Is the economy growing? Is Real GDP going up? Are standards of living (real GDP per capita) increasing?
  • Price Stability:  Are product price changes signs of real changes in relative scarcity of the product?  Or do they indicate that our money is losing/gaining value? Is there any inflation or deflation distorting markets? Is the price index changing?
  • Stability: Is growth smooth and predictable, or are we cycling through booms and recessions? Is the economy predictable enough to make plans?
  • Full Employment: Do we have full employment? Are we using our most important resource (people) fully? What’s the unemployment rate?

In the next few units we will examine ways to measure an economy’s performance on toward these goals.  It’s not as simple as you might first think.