A Level Economics 71: The Circular Flow Model

The circular flow model is a simplified representation of how goods, services, and money flow through an economy. It illustrates the interactions between households and businesses and how they participate in the production and consumption of goods and services. The model consists of two main sectors: the household sector and the business sector.

Assumptions of the Circular Flow Model:

1. There are only two sectors in the economy: households and businesses.
2. The economy is a closed system with no external trade or government involvement.
3. All income earned by households is either spent on consumption or saved.
4. Businesses use all their revenue to pay for factors of production, such as labor and capital.

Components of the Circular Flow Model:

1. Households: Households are the owners of resources, such as labor, land, and capital. They supply these resources to businesses in return for income. In the circular flow model, households are depicted as the source of labor and as consumers who purchase goods and services from businesses.

2. Businesses: Businesses are the producers of goods and services. They hire labor and purchase other inputs from households and produce goods and services that are sold to households.

3. Factor Market: The factor market is where businesses purchase the factors of production from households. Households provide labor, land, and capital in exchange for wages, rent, and profits.

4. Product Market: The product market is where businesses sell goods and services to households. Households, in turn, spend their income on purchasing these goods and services.

The Circular Flow and Equilibrium: In an economy, the circular flow reaches equilibrium when the total amount of goods and services produced (output) matches the total amount of goods and services consumed (expenditure) by households. Additionally, equilibrium means that the total income earned by households is equal to the total income spent on goods and services by businesses.

Key Terms in the Circular Flow:

1. Injections: Injections are additions of income to the circular flow of income and spending that do not arise from the normal activities of households and firms. These injections are external to the circular flow and include three main components: investment, government spending, and exports.

2. Withdrawals: Withdrawals are leakages from the circular flow of income and spending. They represent funds that are taken out of the circular flow and do not return as spending on goods and services. There are three main types of withdrawals: savings, taxes, and imports.

Explanations of Injections and Withdrawals:

1. Injections: a) Investment: Investment represents the spending by businesses on capital goods, such as machinery, equipment, and infrastructure, to expand their production capacity and enhance future output. When businesses invest, they inject funds into the circular flow of income, leading to increased economic activity and potential employment opportunities. For example, a construction company building a new factory is making an investment injection into the economy.

b) Government Spending: Government spending refers to the expenditure by the government on public goods and services, welfare programs, education, healthcare, and infrastructure projects. When the government spends, it injects funds into the circular flow, which can boost overall demand and support economic growth. For instance, a government allocating funds to build schools and hospitals is making a government spending injection into the economy.

c) Exports: Exports represent the sale of goods and services produced in a country to foreign markets. When a country exports, it generates income from outside its domestic economy, adding to the circular flow of income. Exports are an important injection as they contribute to a country's economic growth and can create employment opportunities in export-oriented industries. For example, when a country exports cars to foreign markets, it is making an export injection into its economy.

2. Withdrawals: a) Savings: Savings are the portion of household income that is not spent on consumption but set aside for future use or investment. When households save, funds are withdrawn from the circular flow, reducing the overall spending in the economy. While saving is essential for capital formation and investment, excessive saving can lead to reduced demand for goods and services, potentially slowing down economic growth.

b) Taxes: Taxes are compulsory payments made by households and businesses to the government. When taxes are collected, they represent a withdrawal from the circular flow, as the funds are not available for immediate consumption or investment. While taxes are necessary to fund government services, excessive taxation can reduce disposable income and, in turn, lower consumer spending and business investment.

c) Imports: Imports are the purchase of goods and services from foreign markets. When a country imports, it represents a withdrawal from the circular flow as funds flow out of the domestic economy to pay for foreign-produced goods and services. While imports allow consumers to access a variety of products, excessive reliance on imports can affect domestic industries and lead to a trade deficit.

Injections and withdrawals play a crucial role in determining the equilibrium income, output, and expenditure in an economy. Equilibrium occurs when total injections into the circular flow are equal to total withdrawals. Let's examine the impact of injections and withdrawals on the equilibrium:

1. Impact of Injections:

• When injections exceed withdrawals, it leads to an increase in total demand in the economy. This additional demand stimulates businesses to increase production to meet the higher level of expenditure. As a result, output and income increase, leading to a higher equilibrium level.
• For example, if the government increases its spending on infrastructure projects (injection), businesses will experience higher demand for construction-related goods and services. This can lead to increased output and income in the construction industry and related sectors, contributing to an expansion of the economy.

2. Impact of Withdrawals:

• When withdrawals exceed injections, it reduces the total demand in the economy. This reduction in demand may cause businesses to scale back production, leading to lower output and income in the economy.
• For instance, if households increase their savings rate (withdrawal), it reduces their spending on goods and services. This reduction in consumer spending can lead to a decrease in business revenue, leading to lower production and income.

3. Achieving Equilibrium:

• Equilibrium occurs when injections equal withdrawals. At this point, the total demand in the economy matches the total supply, resulting in a balanced level of output, income, and expenditure.
• For example, if the government increases its spending (injection) while also increasing taxes (withdrawal) by an equal amount, the net effect on total demand is zero. This would lead to a balanced equilibrium where total injections equal total withdrawals.

Policy Implications:

• Policymakers often use injections and withdrawals as tools to influence the equilibrium level of income and output in the economy.
• During periods of economic recession or slowdown, policymakers may increase injections, such as government spending on public projects, to stimulate demand and boost economic activity.
• Conversely, during periods of inflationary pressures, policymakers may implement measures to reduce injections, such as raising interest rates or decreasing government spending, to curb excessive demand and control inflation.

In summary, injections and withdrawals are vital determinants of equilibrium income, output, and expenditure in an economy. When injections exceed withdrawals, it leads to higher demand and increased economic activity, while the opposite scenario may result in reduced demand and economic contraction.

Multiplier Effect and Equilibrium:

The multiplier effect refers to the process by which an initial change in injections (such as investment, government spending, or exports) leads to a larger final impact on the equilibrium income and output of an economy. It occurs due to the circular flow of income, where an increase in injections results in increased consumer spending, which, in turn, generates more income for businesses, leading to further spending and income creation. The multiplier effect amplifies the initial injection, creating a larger overall impact on the economy.

Understanding the Multiplier Effect:

1. Initial Injection: Suppose the government increases its spending on public infrastructure projects by $100 million. This additional government spending is an injection into the circular flow of income.

2. Increase in Consumer Spending: With the $100 million spent on infrastructure, construction companies receive more income. The workers employed in these projects now have more money, which they, in turn, spend on goods and services like food, clothing, and entertainment.

3. Increased Business Income: The increased spending by consumers boosts the revenue of businesses producing these goods and services. As a result, businesses experience a rise in their income.

4. Further Rounds of Spending: The businesses, in turn, spend their increased income on paying wages to their employees, purchasing raw materials, and investing in their operations. These payments and investments create additional income for households and other businesses, leading to further rounds of spending and income creation.

5. Multiplier Effect: The process continues in multiple rounds, with each successive round resulting in a smaller increase in spending and income. The total increase in income throughout these rounds is the multiplier effect.

Impact on Equilibrium: The multiplier effect has a substantial impact on equilibrium income and output. As the initial injection leads to additional spending and income creation, the total effect is greater than the initial injection alone. This increase in overall spending raises the equilibrium income and output of the economy.

Example: Suppose the initial government spending injection of $100 million has a multiplier of 2. This means that for every dollar of government spending, the equilibrium income increases by $2.

Initial Injection: $100 million First Round of Spending: $100 million x 2 = $200 million Second Round of Spending: $200 million x 2 = $400 million Third Round of Spending: $400 million x 2 = $800 million

In this example, the final impact of the initial $100 million government spending injection on the equilibrium income is $800 million, which is significantly larger than the initial injection.

Link to Injections and Withdrawals: The multiplier effect is closely tied to injections and withdrawals in the circular flow of income. Injections, such as government spending, investment, and exports, create additional income and spending, which leads to a positive multiplier effect, increasing equilibrium income and output. Conversely, withdrawals, like savings, taxes, and imports, reduce spending and income, leading to a negative multiplier effect and potentially decreasing equilibrium income and output.

In conclusion, the multiplier effect is a powerful concept in macroeconomics, showcasing how initial injections into the circular flow can lead to substantial changes in equilibrium income and output. Understanding the multiplier effect is crucial for policymakers to design effective fiscal and monetary policies to stimulate economic growth and maintain economic stability.

An Iconoclast to lead the Central Bank

We need an iconoclast to lead the Bank of England

Central bankers are acting like allied commanders at the Battle of the Somme. Adair Turner would be a breath of fresh air

• 
• • Simon Jenkins
  • The Guardian, Tuesday 9 October 2012 21.00 BST

Adair Turner's most celebrated soundbite, in 2009, was that British banking is over-large, and much of it is overpaid and ‘socially useless'. Illustration: Belle Mellor

How to wreck Adair Turner's chances of becoming next governor of the Bank of England? Answer, name him as the best candidate fit for the job. For the first time in modern history it really matters who is governor. It matters that the person should have a grasp not just of the shambles that is modern banking but of the rigor mortis now afflicting Britain's economic managers. They desperately need someone with the guts for new ideas.

Turner has been a banker and an economist, two professions most tainted by the past five years. Bankers are tainted by venality, economists by intellectual failure. No one involved is free of guilt. No one has gone to jail, and only a few high-profile bankers have even suffered. What matters is have they learned?

Today the IMF predicted that Britain has relapsed into recession and should "smooth its planning adjustment over 2013 and beyond", jargon for "let up on austerity". Whether such IMF forecasts merit more credibility than the wildly over-optimistic ones last year, I cannot tell. Certainly the blunders have been serious. A cut of £1 in public spending apparently does not lead to 50p less economic activity but at least £1.30p less. The "multiplier effect" of deficit reduction is thus a downward deflationary spiral. This is not ideology, but the mathematics of catastrophe.

Those who warned three years ago that the risk of double-dip recession was so high as to require a plan B were right. The Treasury, the Bank of England and the IMF were wrong. The fact that the Treasury has had to propose six ineffective business lending packages in a row, and the Bank has had to pretend to pump £375bn "into the economy" is proof of that failure. I do not believe for a minute that George Osborne and his advisers, had they correctly predicted the recession, would be following the present policy. At least the IMF is now admitting its mistake.

Government and Bank economists are continuing to allow politicians to cop out of reflating demand for fear of a U-turn. Economists are like physicians in the days when they believed in leeches. They take no responsibility for gross errors that would get doctors struck off, and even transport officials suspended.

Turner is criticised as a dabbler and turncoat, a McKinsey consultant and a poor administrator. He was Tory, then SDP, then Blair courtier, an academic economist turned head of the CBI. He was a poacher turned regulator at the Financial Services Authority. He ran pensions and low-pay policy and is unceasingly iconoclastic and articulate. To adapt Ruskin, a hundred economists may look, but few can see. Turner can see. His opinions can be deduced from a torrent of outspokenness. His most celebrated soundbite, in 2009, was that British banking is over-large, and much of it is overpaid and "socially useless". As free markets mature, he says, insiders merely collude to "proliferate rent-extracting opportunities" – that is, make huge sums of money. They should be curbed.

Three of Turner's lectures, delivered in 2010 and now revised as "Economics after the Crisis", are eulogistically reviewed by Robert Skidelsky in the latest Times Literary Supplement. Turner maintains that economics has blown too much with the political wind. It has ordained that growth is in lock-step with social order and human happiness. It is not. He does not go the whole happiness agenda but nods vigorously in its direction. Nor do wider incentives yield fairness or evidence of contentment.

This does not seem leftwing – rather pragmatic. Increased leisure may be good yet impair growth. Market forces do not correctly price risk, as we have just seen in spades, but can spin off into an instability. The task of regulation, says Turner, is to curb upturns and minimise downturns, as Keynes ordered. It should have warned politicians against the debt bubbles and housing hysteria of the last decade.

Turner seeks to "reconstruct economics" not as anti-capitalist but, Skidelsky points out, as a challenge to "an unattainable market perfection" that can so clearly lead to periodic collapses and a huge cost to human welfare. There is a moral complexity to economics that is both necessary and difficult.

As for present policy, Turner seems to agree with the IMF that Britain has over-deflated its economy. In July he told the Bank's monetary policy committee that it faced a liquidity trap in which quantitative easing "was proving to have little impact on behaviour and on demand". Using the banks to stimulate the economy – the core of Treasury and Bank policy – was "ineffective". This amounted to saying that recession was now government-induced.

Turner's more private view is that Britain should consider whether debt should now be "monetised", financed by blatantly printing money rather than buying bank bonds and hoping this boosts demand. His is a version of the "helicopter" money advocated by JM Keynes and Milton Friedman. Turner points out that actually printing money – not pretending to as at present – would involve "no increase in government debt and therefore no increase in future debt servicing". It is pure inflation and needs careful handling, but just now it is like pouring oil on a seized engine. On the spectrum from plunging deflation or hyper-inflation, the risk of the former far outweighs the latter. At very least, this should be discussed.

Britain's central bankers are like allied commanders during the Somme, sticking blindly to a defunct strategy out of sheer familiarity. Turner's scepticism seems no more than prudent. In this context, a Bank governor steeped in the financial establishment but with an observant eye and a mind open to argument is more than a breath of fresh air. It is one thing that might jolt us out of the present mess.

How Quantitative Easing will not solve the problem - An alternative viewpoint

Professor Steve Keen was one of the few economists to predict the financial crisis. According to him, the “debt-deflationary forces” unleashed today “are far larger than those that caused the Great Depression.”

George Monbiot

I stumbled out into the autumn sunshine, figures ricocheting around in my head, still trying to absorb what I had heard. I felt as if I had just attended a funeral: a funeral at which all of us got buried. I cannot claim to have understood everything in the lecture: Sonnenschein-Mantel-Debreu Theory and the 41-line differential equation were approximately 15.8 metres over my head(1). But the points I grasped were clear enough. We’re stuffed: stuffed to a degree that scarcely anyone yet appreciates.

Professor Steve Keen was one of the few economists to predict the financial crisis. While the OECD and the US Federal Reserve foresaw a “great moderation”, unprecedented stability and steadily rising wealth(2,3), he warned that a crash was bound to happen. Now he warns that the same factors which caused the crash show that what we’ve heard so far is merely the first rumble of the storm. Without a radical change of policy, another Great Depression is all but inevitable.

The problem is spelt out at greater length in the new edition of his book Debunking Economics (4). Like his lecture, it is marred by some unattractive boasting and jostling. But the graphs and figures it contains provide a more persuasive account of the causes of the crash and of its likely evolution than anything which has yet emerged from Constitution Avenue or Threadneedle Street. This is complicated, but it’s in your interests to understand it. So please bear with me while I do my best to explain.

The official view, as articulated by Ben Bernanke, chairman of the Federal Reserve, is that both the first Great Depression and the current crisis were caused by a lack of base money. Base money, or M0, is money that the central bank creates. It forms the reserves held by private banks, on the strength of which they issue loans to their clients. This practice is called fractional reserve banking: by issuing amounts of debt several times greater than their reserves, the private banks create money that didn’t exist before. Conventional economic theory predicts that when the central bank raises M0, this triggers a “money multiplier”: private banks generate more credit money (M1, M2 and M3), boosting economic growth and employment.

Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was propelled by a fall in the supply of M0, which, he said, “reinforced … declines in the money multiplier.”(5) But, Keen shows, there is a weak association between M0 money supply and depression. There were six occasions after World War Two when M0 money supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s(6). In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results which defy Bernanke’s explanation. Steve Keen argues that it’s not changes in M0 which drive unemployment, but unemployment which triggers changes in M0: governments issue more cash when the economy runs into trouble.

He proposes an entirely different explanation for the Great Depression and the current crisis. Both events, he says, were triggered by a collapse in debt-financed demand(7). Aggregate demand in an economy like ours is composed of GDP plus the change in the level of debt. It is the sudden and extreme change in debt levels that makes demand so volatile and triggers recessions. The higher the level of private debt, relative to GDP, the more unstable the system becomes. And the more of this debt that takes the form of Ponzi finance – borrowing money to fund financial speculation – the worse the impact will be.

Keen shows how, from the late 1960s onwards, private sector debt in the US began to exceed GDP. It built up to wildly unstable levels from the late 1990s, peaking in 2008. The inevitable collapse in this rate of lending pulled down aggregate demand by 14%, triggering recession(8).

This should be easy enough to see with the benefit of hindsight, but what lends weight to Keen’s analysis is that he saw it with the benefit of foresight. In December 2005, while drafting an expert witness report for a court case, he looked up the ratio of private debt to GDP in his native Australia, to see how it had changed since the 1960s. He was astonished to discover that it had risen exponentially. He then did the same for the United States, with similar results(9). He immediately raised the alarm: here, he warned, were the conditions for an economic crisis far greater than those of the mid-1970s and early 1990s. A massive speculative bubble was close to bursting point. Needless to say, he was ignored by policy-makers.

Now, he tells us, a failure to address these problems will ensure that this crisis will run and run. The “debt-deflationary forces” unleashed today “are far larger than those that caused the Great Depression.”(10) In the 1920s, private debt rose by 50%. Between 1999 and 2009, it rose by 140%. The debt-to-GDP ratio in the US is still much higher than it was when the Great Depression began(11).

If Keen is right, the crippling sums spent on both sides of the Atlantic on refinancing the banks are a complete waste of money. They have not and they will not kickstart the economy, because M0 money supply is not the determining factor.

President Obama justified the bailout of the banks on the grounds that “a dollar of capital in a bank can actually result in $8 or $10 of loans to families and businesses. So that’s a multiplier effect”(12). But the money multiplier didn’t happen. The $1.3tn that Bernanke injected scarcely raised the amount of money in circulation: the 110% increase in M0 money led not to the 800 or 1000% increase in M1 money that Obama predicted, but a rise of just 20%(13). The bail-outs failed because M0 was not the cause of the crisis. The money would have achieved far more had it simply been given to the public. But, as Angela Merkel and Nicholas Sarkozy demonstrated over the weekend(14), governments have learnt nothing from this failure, and seek only to repeat it.

Instead, Keen says, the key to averting or curtailing a second Great Depression is to reduce the levels of private debt, through a unilateral write-off, or jubilee. The irresponsible loans the banks made should not be honoured. This will mean taking many banks into receivership(15). Otherwise private debt will sort itself out by traditional means: mass bankruptcy, which will generate an even greater crisis.

These are short-term measures. I would like to see them leading to a radical reappraisal of our economic aims and moves to develop a steady-state economy, of the kind proposed by Herman Daly and Tim Jackson(16). Governments and central bankers now have an unprecedented opportunity to learn from the catastrophic mistakes they’ve made. It is an opportunity they seem determined not to take.

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www.monbiot.com

References:
1. Professor Steve Keen, 6th October 2011. Alternative theories of macroeconomic behaviour: a critique of neoclassical macroeconomics and an outline of the alternative Monetary Circuit Theory approach. Nuffield College, Oxford.
2. Ben Bernanke, 20th February 2004. The Great Moderation. http://www.360doc.com/content/11/0402/23/67028_106822017.shtml
3. Jean-Philippe Cotis, May 2007. Achieving further rebalancing. OECD Economic Outlook. http://findarticles.com/p/articles/mi_m4456/is_81/ai_n27271380/
4. Steve Keen, 2011. Debunking Economics: revised and expanded edition. Zed Books, London.
5. Ben Bernanke, 2000. Essays on the Great Depression, page 153. Princeton University Press. Quoted by Steve Keen, as above.
6. Steve Keen, page 302.
7. Page 300.
8. Page 341.
9. Page 336-337.
10. Page 349.
11. Page 348.
12. Barack Obama, 14th April 2009. Remarks on the economy. http://www.whitehouse.gov/the-press-office/remarks-president-economy-georgetown-university
13. Page 306.
14. http://www.guardian.co.uk/business/2011/oct/09/france-germany-agree-plan-banks
15. Page 355.
16. http://www.monbiot.com/2011/08/22/out-of-the-ashes/