Modeling the Economy

Actors:

1. Consumers2. Financial Institutions3. Businesses4. The Government5. The Foreign Sector

Circular Flow Model

Consumers can engage in 3 actions:

1. Consumption (C)2. Savings (S)3. Paying Taxes (T)

FinancialInstitutions

S C Consumers

TGovernment

Injection: Something that causes GDP to increase

Consumption is the first of 4 possible injections

Leakages – things that, if increased, will lower GDP

Two of the three leakages in the economy are:

1. Savings2. Taxes

Financial Institutions are:

1. Banks2. The Stock Market3. The Bond Market

Consumers can borrow money to finance consumption (CB)

ex: car loan

Businesses can borrow money or sell stock in order to pay for new investment

Investment (I) is the second injection into the economy

Just because money is saved doesn’t mean that it is invested

Financial stocksBusinessesInstitutions bonds I

CB S C Consumers

TGovernment

The Government

1. Collects Taxes (T) – leakage2. Spends Money (G) - injection3. Borrows Money (GB)4. Gives Transfer Payments to people (TP)

If the government spends more than it collects in taxes, it has a budget deficit and must borrow money

A budget surplus exists when the government spends less than it collects in taxes

Financial stocksBusinessesInstitutions bonds I

CB S C ConsumersTP TGovernment GB

G

The Foreign Sector

1. Buys things made in the USexports (X) are the 4th injection

2. Sells things to the USimports (IM) are the 3rd leakage

3. Saves (FS)/ Borrows (FB)Money

If exports are greater than imports, then the US has a trade surplus

If imports are greater than exports, then the US has a trade deficit

http://www.census.gov/indicator/www/ustrade.html

FSFinancial stocksBusinesses FBInstitutions bonds I Foreign

SectorCB S C X IM ConsumersTP TGovernment GB

G

Injections:

1. Consumption (C)2. Investment (I)3. Government Spending (G)4. Exports (X)

Leakages:

1. Taxes (T)2. Savings (S)3. Imports (IM)

Every time something gets made, someone gets paid

1. labor is paid wages2. capital is paid interest3. land is paid rent4. entrepreneurs are paid profit

FSFinancial stocksBusinesses FBInstitutions bonds I Foreign

SectorCB S C X IM ConsumersTP TGovernment Income GB wages, interest, rent, profit G