Circular Flow of Income (2)
The One Lesson view of the 2-sector model
In the last post we saw how macroeconomists model the economy of a nation by assigning each person (or corporation) to a sector, and looking at the flows of money between these sectors, with a special focus on firms (where production takes place) and households (who need to consume goods and services produced by firms).
But where do these “factors”, and goods and services come from, and where do they go? In this post, we’ll look at the One Lesson’s version of the model which fills in some of the gaps left by the traditional model above, so it’s more like the real world, making it more intuitive.
For now we’ll stick to having 2 sectors. Some circular flow models add other sectors, such as government, banking/financial, and foreign. We’ll look at those later in this series.
What’s missing?
The traditional model, like much of economics, only looks at trade. It doesn’t say much about the actual production and consumption of goods and services. This is a big weakness, because it doesn’t distinguish between goods which are bought and instantly consumed, and goods which provide benefits to the owners over many years. Or between firms which have goods ready to sell, and firms which have nothing.
What goods and services are produced and consumed?
The obvious ones are the goods and services produced by firms and sold to households. Only their sale is shown in the traditional circular flow model.
The labour of employees is also a service. The employees put in work which benefits firms (for which the employees are paid money). This is also shown in the traditional circular flow model.
What is missing from the diagram is (working backwards):
Households consuming the goods and services which they’ve bought.
Firms producing those goods and services.
Firms consuming “intermediate” goods/services in the process of producing other goods and services (e.g. iron ore and fuel when making steel).
Firms producing these intermediate goods/services.
Once we add these in, we get a much more intuitive 2-sector model of the economy.
Let’s look at each of the arrows carefully, starting with the parts familiar from the traditional 2-sector circular flow model.
Household income (Y). Money paid by firms to households in exchange for factors.
Factors. Anything done by households which help a firm to produce, in particular employment, but this also includes providing other resources to a firm1.
G/S (final) = final goods and services. “Final” means they are for the households to use and consume, not for firms to use in producing more goods and services.
HS = household spending. This is called “consumption” in the traditional model. As we saw in the last article, that’s misleading. If Alice buys a fridge, that’s counted by the traditional model as consumption, even though it will probably serve her for many years — it isn’t being consumed immediately.
Now for the parts which the traditional model ignores:
HC = household consumption. This is actual consumption, such as if a household’s boiler breaks down (sore point!), they eat some of the food they’ve bought, or they strip off old wallpaper to replace it. The need and desire for household consumption is the entire purpose of the economy.
PF = production of final goods and services. This is the production of the goods and services to be sold to households. Goods are stored by the firm until they are sold. (Services can’t be stored: they’re immediate transferred to households as part of G/S (final), and consumed as part of HC).
CI = consumption of intermediate goods and services. This could be consumption of flour and salt when making bread. It also includes using components to make a new product, even if they can be recovered later. For example, a car wheel is an intermediate good which is “consumed” when producing a car. Once the car is made, the wheel is no longer a product available for use in its own right2.
PI = production of intermediate goods and services. This is creating goods and services to be used by other firms in their production3.
Some intermediate goods and services are used to produce other intermediate goods and services. For example, wheat is an intermediate good, used to produce flour, which is itself an intermediate good used by bakers to produce bread. Even the bread can be an intermediate good if it’s sold to a sandwich shop.
Analysis
Following the One Lesson, let’s look at how each sector’s raw net worth4 is affected.
First, households.
Money. Over the time period, households’ stock of money increases by household income (Y), but decreases by household spending (HS).
Goods. Over the time period, households’ stock of goods increases by the goods they buy from firms (G/S (final)), and decrease by what they consume (HC).
Other debts. Other than the money, there are no debts in this simple model of the economy.
Now firms.
Money. Over the time period, firms’ stock of money increases by household spending (HS), but decreases by household income (Y).
Goods. Over the time period, firms’ stock of goods increases by what they produce (PI + PF), and decreases by what they consume (CI) and what they sell to households (G/S (final)).
Other debts. Again, other than money, there are no debts in this model.
We can summarise this as follows:
Households, by working for firms, earn a money income (Y) which allows them to buy goods and services from firms to supply their consumption needs and wants.
If they spend less money than their money income, they’re adding to their stock of money, so they can spend more than their income later. If they spend more money than their income, they’re depleting the stock of money they accumulated earlier, and can eventually run out.
If they consume fewer goods than they buy, they’re adding to their stock of goods, so they can consume more than they buy later. If they consume more goods than they buy, they’re depleting their stock of goods, and can eventually run out.
Firms, by producing more goods and services than they consume in the process, can earn money by selling them, which allows them to pay households for factors.
If they spend less money on factors than their income from selling goods and services, they’re adding to their stock of money, so they can spend more than their income later. If they spend more money than their income from selling goods and services, they’re depleting the stock of money they accumulated earlier, and can eventually run out.
If they consume or sell fewer goods than they produce, they’re adding to their stock of goods, so they can consume or sell more than they produce later. If they consume or sell more goods than they produce, they’re depleting their stock of goods, and can eventually run out.
The whole world isn’t affected by any of the trading, which is all internal transfers. Its RNW simply increases by production (PF + PI) during the period, and decreases by consumption (CI + HC).
If it consumes fewer goods than it produces, it’s adding to the world’s stock of goods, so it can consume more than it produces later. If it consumes more goods than it produces, it’s depleting its stock of goods, and can eventually run out.
Summary
The circular flow of income is a useful starting point for thinking about the economy over a period of time. But it’s incomplete because it doesn’t include production and consumption. When these are added to the model, it becomes much clearer what’s going on: each sector’s stock of money is being built up and depleted as it sells more than it spends or vice-versa; and each sector’s stock of goods is being built up and depleted as it produces/buys or consumes/sells more.
Including these stocks in the model helps to avoid incorrect reasoning which makes assumptions about the economy always being in an equilibrium, where flows are equal in each direction.
This model doesn’t show households investing money in firms, but it’s worth being aware that this (and the use of land) is included in “factors” — it’s not just labour (employment).
You can take the wheel off the car, but then you don’t have a complete car any more. It’s best to think of doing that as consuming the car in the process of producing both a wheel and an incomplete car (one which is missing a wheel).
Intermediate goods are usually sold from one firm to another. We don’t see this in the diagram because all the firms have been grouped together, so the transfer of money is internal to the group.
Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe. It is a “heterogeneous” sum/difference, which just means that things of different types are added and subtracted, not monetary “values” which have been assigned to them.