MODEL 0. The Simple Circular Flow. Numerical exercises

PrM

CrM

H&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

S = I. If and when the Credit Market is working wellFor now we will assume S = I

MODEL 0 PrM

CrM

H&B

X

Y

C

I

S

Y = C + S. X = C + I. S = I.

The first exercise will be: What happens if Consumption rises by 10 with no change of Income?

PrM

CrM

H&B

+10

Show the change of C on the diagram

-10

If we Consume more, we must Save less, since Y did not change.

-10

Since Savings has fallen and S = I, Investment must fall as well.

+0

+0

Note that total spending has not changed because the increase of Consumption was off-set by the decrease of Investment

MODEL 0 PrM

CrM

H&B

X

Y

C

I

S

Exactly this same question could have been posed as, “What is Saving had fallen by 10?” (with no change of Income)

PrM

CrM

H&B

+10

-10

-10

+0

+0

Less Saving allows more Consumption, but requires less Investment.

Y = C + S. X = C + I. S = I.

MODEL 0 PrM

CrM

H&B

X

Y

C

I

S

Y = C + S. X = C + I. S = I.

Next Question: What if Investment were to rise by 10 (as will always be the case we will not let Income change.)

+10

-10

+10

+0PrM

CrM

H&B+0

More Investment…

… requires more Saving

… which requires less Consumption

And again X does not change.

Keep in mind the critical importance of Investment. Although the Model does not show it, Investment will determine future growth

INVESTMENT, CONSUMPTION and SAVING

Consumption is spending for now, Investment is spending for later.

This Model will constantly point out the choice that must be made between “now” and “later.” Saving is what links the two.

The other characteristic of this Model is the fact that Total Spending (X) does not change. X can neither rise nor fall.

The first problem with this model is that it clearly does not reflect the reality that during most of US history total spending (GDP) has risen and that GDP has occasionally fallen (i.e. recessions have occurred).

We need to add one or both of two other elements.

1. Supply-side growth due to improvements of the FOPs. The Circular Flow Model is essentially a Demand-Side Model

2. “Cash” – Flexibility in the Credit Market

We can see the supply-Side growth in the US 1800s by the on-going real growth + deflation

The Laws of Supply and Demand – with the Product Market Equation – illustrate the Industrial Revolution as a period of supply growth with the resulting lower prices and expanding real output

But the 1800s also have1. war-time expansions, which appear to be periods of

rising demand and2. recurring recessions, which appear to be periods of

falling demand.

Model 0 cannot explain those