The Circular Flow Diagram

You have undoubtedly heard the phrase: a picture is worth a thousand words.  This is certainly true when we are talking about macroeconomics.  The market economy is an incredibly complex system and it is very easy to get lost in the details, to lose sight of the 'big picture' as you read, or listen to, the countless discussions of the economy and economic policy.  In 1998 it was difficult to pick up a paper or listen to nightly news without hearing about the Asian crises, the US stock market, tax cuts and the budget surplus, Alan Greenspan's interest rate decisions, recession, and deflation.  

It is also easy to suffer a severe case of data overload when you look at the "numbers" the US government collects on all facets of the US economy. With today's technology, you have at your fingertips access to a wealth of data on the US and international economies and you can even, with virtually no effort, generate some time-series graphs. It has not always been this way. In fact, before WW II there was very little centralized collection of macroeconomic data because there was no reason to collect the data at that time. Measurement is an essential element in management - you cannot have management without measurement - but prior to the Depression there was simply no belief in any merit to government management of the macroeconomy, and therefore there was no demand for the numbers. The arrival of Keynes in the 1930s with his view that the government could effectively manage the macroeconomy generated a demand for macroeconomic numbers which the government began to collect.

To provide the basis for an understanding of the macroeconomy, in this unit of the course we will briefly discuss a few simple models and then some of the more important economic indicators of the macroeconomic performance. We will begin our work with a picture of the economy - the Circular Flow Diagram and the accompanying Classification Scheme (chart below). 

The Classification Scheme is useful because it identifies the major actors in the macro economy, the arenas or markets in which they interact as buyers and sellers, and the primary measures of activity in each market. Under this scheme there are four sets of markets (output, labor, capital, and foreign exchange), four groups of decision makers (households, firms, government, and foreigners), and a number of indicators of the activities in these markets (GDP, unemployment, interest rates, exchange rates).  All of the market transactions that occur are registered in one of these markets.

Markets Demanders Suppliers Key Concepts
Output Firms Firms GNP, GDP, NDP
  Households   NI, PI, DI
  Government   CPI, PPI
  Foreign   Productivity
Labor Firms Households Employment
  Government   Unemployment
      Earnings
Capital Households Households Interest Rates
  Firms FED Stocks, bonds
  Government    
Foreign Exchange Government Households Exchange Rates
  Foreign Firms/ Govt. Trade Flows

Where do you fit into the picture - or where does Sam who runs the super market?   When Sam's Market sells its produce or buys its meat from the wholesaler, or when you buy orange juice at the Emporium or gas at the local station, pay your tuition bills and buy your books, these are transactions that would be recorded in the output market where firms are generally suppliers and individuals are demanders.   You may happen to work for Sam, or maybe you have a work-study job, or a weekend job as a waiter or retail clerk.  These transactions are recorded in the labor market where firms tend to be the buyers and individuals are the sellers of labor services.  Sam's may also buy some lamb imported from New Zealand or jam imported from Germany, while you may buy a stereo player made in Korea, khakis made in Indonesia, a rug made in Tibet, or a sweater made in Ecuador.  Each of these transactions involves the foreign exchange market because each involves international transactions that require exchange of national currencies.  The Germans want German marks for their jam and you have American dollars so your dollars must be converted to German marks - a job for the foreign exchange market

And let's not forget Sam's loan that provides him with the funds to stay in business, his pension contribution that will provide Sam with retirement income, or the student loan that allows you to get your education and checking account that you use to pay your bills. Each of these transactions is recorded in the capital market. The suppliers in the capital market are those firms, individuals, or governments with excess funds that come to the capital market with the funds. Examples would be the purchase of corporate stock or mutual funds, deposits in checking or savings accounts, and contributions to life insurance policies or pension plans. Demanders in the capital market would be those in need of funds - individuals taking a mortgage to buy a home, businesses selling stock to raise funds for expansion, or governments selling bonds to pay for a budget deficit.

To understand the nature of the interrelations between the markets, you should begin with the circular flow diagram. The diagram is useful for four reasons. First it provides a basis for organizing the wide array of macroeconomic indicators. In the following sections you will find that the macroeconomic variables are organized according to the market which they describe, but there are notable similarities in the patterns of many of the indicators and these similarities cut across market boundaries. This is as you should expect. The capitalist system binds the separate markets together closely so events that 'shock' one market are likely to have an effect on the other markets.

The diagram is also valuable because the picture allows one to "visualize" the interrelationships between the aggregate markets.  The Circular Flow Diagram allows you to follow the flow of money through the system.  You can start anywhere and then follow the flow through the system.  For example, let's start in the output market and keep it real simple.  The firms bring their "stuff" to the output market and they pay their workers and investors wages and dividends equal to the value of what they bring to the market.  If we had a meter that measured the value of what the firms brought to the markets, it would be measuring Gross Domestic Product (GDP), and if we measured what the firms pay out to the inputs used to produce the "stuff," we would have national income (NI). 

Now what happens to the income received by the households (wages and dividends)?   Some of it "leaks" out of the system as taxes that are offset to some extent by transfer payments (ex. unemployment and social security benefits).   Households then divide the remainder of their income between consumption of "stuff" (ex. buying gas for the car, books for school) and savings (ex. deposit in savings account, purchase of stock) which is another leakage from the system.   Some of what individuals buy, however, was produced abroad so another leakage from the system would be imports (ex. purchase of French wine, German cars, and Asian electronics). 

But what happens to the taxes, savings, and imports that leak out of the system? At this point some of the income the firms paid out to their workers has left the system so there will not be enough money left in the system to buy all of the "stuff" that was brought to the market.  As we will see later, if the system is to be sustainable, then there will need to be offsetting injections into the system.  One of those injections would be Investment spending, business spending on new factories and machines.  Firms would go to the capital market to borrow funds to finance their their buying of "stuff."  The net taxes drained from the system will be recycled by the government - they will emerge as Government spending on missiles for defense, public school teachers to provide education, and judges to provide the "rules."  If the government spent more than it took in,  it would need to go to the capital market to borrow funds to cover the budget deficit.  As for the funds that leaked from the system to pay for imports, they would pass through the foreign exchange market and reemerge as an injection of funds back into the system when the rest of the world bought our exports of "stuff."  If we combine the demand for stuff - Consumption, Investment, and Exports - and then subtract what was purchased from abroad -Imports- we have Aggregate Demand, a concept we will spend a good amount of time analyzing.

We have now traced the flow of funds from the output market, through the complex system of aggregate markets, and then back. It is an understanding of the interaction between these markets which is the key to an understanding of macro economic theory and the workings of discretionary monetary and fiscal policy. For example, a crash in the price of stocks which occurs in the US financial market, is likely to have a negative impact on the output and labor market. As individuals perception of their wealth is eroded as a result of the shock, they may reduce their consumption expenditures which will reduce aggregate demand in the output market. As firms cut back their output to bring production in line with demand, there will be layoffs which will be reflected in employment declines and a rise in the unemployment rate. Similarly, the decision by OPEC to raise the price of oil, which directly affects the output market, will certainly have impacts which are felt in the labor and financial markets. 

The circular flow diagram is also valuable as a graphic representation of the important macro economic accounting identities.  These identities form the basis for the macro measurement section, where we examine the major indicators of macroeconomic performance, and the equilibrium conditions, which form the basis for the macro theory part of the course. At the outset, you should be careful to avoid any confusion between the macro identities and the equilibrium conditions. Although the conditions look very similar, they are quite different. The macro identities are essentially accounting constructs which exist by definition, while the equilibrium conditions are conditions which need not exist if the economy is in the midst of adjusting to some external shock. These equilibrium conditions will provide the organizing principles for a later discussion of alternative macroeconomic theories, but for now we will focus on the macro identities.

The circular flow diagram also helps one better understand the aggregate supply - aggregate demand model that we will use extensively during the semester can be viewed as a visual representation of what goes on in the output market.  Although the model looks so very much like the supply-demand model that economists have used to model individual markets in microeconomics, it is not and the circular flow diagram helps us see beyond the deceptive simplicity.  By highlighting the interactions between the various markets, it is easier to see how developments in any of the other markets need to be reflected in the AD and AS curves.