THE MACROECONOMIC CIRCULAR FLOW PART II

1. THE MACROECONOMIC CIRCULAR FLOW PART II

2. Businesses 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

3. PRODUCT MARKET SPENDING (GDP) Businesses I N C O M E By simplifying, we can split total income into two broad streams. Income to Households we’ll call “Wages.” Income to Business we’ll call “Profit.” P R O F I T W A G E S Households

4. PRODUCT MARKET SPENDING Businesses 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 I N C O M E W A G E S P R O F I T Current Domestic Spending Uses of Income Households Uses of Income

5. PRODUCT MARKET SPENDING D O M E S T I C C O N S U M P T I O N SO LET’S SIMPLIFY I N C O M E 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. DOMESTIC PRIVATE SECTOR Other Uses of Income

6. PRODUCT MARKET SPENDING D O M E S T I C C O N S U M P T I O N So ... what are the other uses of income I N C O M E Remember ...Each of these is the combination of income used by Households and by Businesses T A X E S I M P O R T S S A V I N G DOMESTIC PRIVATE SECTOR Other Uses of Income

7. PRODUCT MARKET SPENDING D O M E S T I C C O N S U M P T I O N I N V E S T M E N T G O V T E X P O R T S I N C O M E We can add back the three other types of spending T A X E S I M P O R T S S A V I N G DOMESTIC PRIVATE SECTOR INCOME

8. PRODUCT MARKET INJECTIONS P U R C H A S E S D O M E S T I C C O N S U M P T I O N G O V T E X P O R T S I N V E S T M E N T I N C O M E INJECTIONS -- the sum of Exports, Investment and Government Purchases TWO MORE TERMS T A X E S I M P O R T S S A V I N G LEAKAGES --the sum of Imports, Saving and Taxes DOMESTIC PRIVATE SECTOR LEAKAGES

9. PRODUCT MARKET INJECTIONS P U R C H A S E S D O M E S T I C C O N S U M P T I O N G O V T E X P O R T S I N V E S T M E N T I N C O M E INJECTIONS – appear to come “from nowhere.” T A X E S I M P O R T S S A V I N G LEAKAGES –appear to go “to nowhere.” HOUSEHOLDS And BUSINESSES LEAKAGES

10. PRODUCT MARKET INJECTIONS P U R C H A S E S D O M E S T I C C O N S U M P T I O N G O V T E X P O R T S I N V E S T M E N T I N C O M E Because spending and income can come from and go to “nowhere” we call this the OPEN MODEL T A X E S I M P O R T S S A V I N G HOUSEHOLDS And BUSINESSES LEAKAGES

11. Again, let’s simplifying the diagram for drawing purposes. Here’s one version -- PrM X Injections G E I C F S T H/B Y Leakages

12. Here’s another simplified version -- PrM X Injections = E + I + G C H/B Y Leakages + F + S + T

13. 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)

14. SPENDING CAN BE BROKEN INTO TWO TYPES • Spending = Consumption + Injections • = from Income + from somewhere else

15. 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.

16. There are four macroeconomic markets 1. The Product Market – where goods and services are produced and sold. 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. 3. The Credit Market – where people with money to lend contact people who want to borrow: banks, the stock market, credit unions, etc.

17. PRODUCT MARKET SPENDING (X) INCOME(Y) CONSUMPTION(C) INCOME (Y) 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. Most Income is then sent back to the Product Market as Consumption. Households And Businesses

18. PRODUCT MARKET C WAGES PROFIT INCOME (Y) SPENDING (X) INCOME The LABOR MARKET splits total Income into two parts: Wages, going mainly to Households, and Profits, going to Businesses and their owners. LABOR MARKET Households And Businesses

19. PRODUCT MARKET SPENDING (X) INVESTMENT(I) The part of income that is not spent (that is saved) goes in to the Credit Market (banks and other saving institutions). Businesses borrow from there to invest (buy capital). The CREDIT MARKET exists to link savings and investment. CREDIT MARKET C Savings(S) H/B INCOME (Y)

20. PrM SPENDING(X) Dollars return to the US when other countries pay for our Exports. Exports(E) The FOREIGN EXCHANGE MARKET exists to allow trade between countries with different currencies. FxM C Imports(F) Dollars leave the US to pay for our Imports from other countries. H/B INCOME(Y)

21. Gov’t Purchases are part of spending PrM SPENDING(X) Gov’t Purchases(G) 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. Budget Balance(BB) TRSY C The Budget Balance usually refers to the “Budget Deficit,” the amount the gov’t has to borrow per year. Taxes(T) H/B INCOME(Y) Taxes are taken from Income

22. But we need to add two more important flows of credit THIS MODEL IS CLOSED PrM X E I G FxM CrM TRSY C T F S H/B Y

23. 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.

24. The Budget Balance inTHE CLOSED MODEL A Budget Deficit (when Purchases exceed Taxes) goes from the Credit Market to the Treasury. PrM X E I G The Gov’t Budget Balance FxM CrM TRSY C BB T F S A Budget Surplus (when Taxes exceed Purchases) goes from the Treasury to the Credit Market. H/B Y

25. 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.

26. K Foreign Capital FlowsinTHE CLOSED MODEL A foreign capital outflow goes from the US credit market to the rest of the world, through the Foreign Exchange Market PrM X Foreign capital can be either an inflow or an outflow E I G FxM CrM TRSY C T F S A foreign capital inflow goes from the rest of the world, through the Foreign Exchange Market, to the US Credit Market. H/B Y

27. Putting this all together we have the CLOSED MODEL

28. THE CLOSED MODEL PrM X E I G FxM CrM TRSY BB C K T F S H/B Y

29. 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.

30. PrM X I CrM C ΔMS S The FED H/B Y To keep things simple we’ll ignore the Foreign Sector and the Treasury THE FEDERAL RESERVE and the MONEY SUPPLY This shows an increase of the money supply. Newly printed money comes out of the Fed and in to the Credit Market

31. PrM X I CrM C ΔMS S The FED H/B Y THE FEDERAL RESERVE and the MONEY SUPPLY This shows a decrease of the money supply. The Fed takes money out of circulation.

32. 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)

33. PrM X I CrM C ΔMD Cash S H/B Y THE CASH BOX and MONEY DEMAND This shows a decrease of the money demand. The public holding less money. The velocity of money is rising.

34. PrM X I CrM C ΔMD Cash S H/B Y THE CASH BOX and MONEY DEMAND This shows a increase of the money demand. The public is holding more liquidity. The velocity of money is falling.

35. 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 • Open • Closed • Money

36. You can imagine any of these being models as being built up from a set of components. • 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.

37. THE END ... for now