riches.”
Introduction to Macroeconomics Part D
by
Charles Lamson
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The Components of the Macroeconomy
Macroeconomics focuses on four groups: (1) households and (2) firms, which together comprise the private sector, (3) the government (the public sector) , and (4) the rest of the world (the international sector). These four groups interact in a variety of ways, many involving either the receipt or payment of income. The Circular Flow Diagram A useful way of seeing the economic interactions among the four sectors in the economy is a circular flow diagram, which shows the income received and payments made by each. A simple circular flow diagram is pictured in Figure 1.   Let us walk through the circular flow step-by-step. Households work for firms and the government, and they receive wages for their work. Our diagram shows the flow of wages into the household sector as payment for those services. Households also receive interest on corporate and government bonds and dividends from firms. Many households receive other payments from the government, such as Social Security benefits, veterans benefits, and welfare payments. Economists call these kinds of payments from the government (for which the recipients do not supply goods, services, or labor) transfer payments. Together, all these receipts make up the total income received by the households. Households spend by buying goods and services from firms and by paying taxes to the government. These items make up the total amount paid out by the households. The difference between the total receipts and the total payments of the households is the amount that the households save or dissave. If households receive more than they spend, they save during the period. If they receive less than they spend, they dissave. A household can dissave by using up some of its previous savings or by borrowing. In the circular flow diagram, household spending is shown as a flow out of the household sector. Saving by households is sometimes termed "leakage" from the circular flow because it withdraws income, or current purchasing power, from the system.  One lesson of the circular flow diagram is that everyone's expenditure is someone else's receipt. If you buy a personal computer from IBM, you make a payment to IBM and IBM receives revenue. If IBM pays taxes to the government, it has made a cover payment and the government has received a revenue. Everyone's expenditures go somewhere. It is impossible to sell something without there being a buyer, and it is impossible to make a payment without there being a recipient. Every transaction must have two sides.  The Three Market Arenas Another way of looking at the ways households, firms, the government, and the rest of the world relate to each other is to consider the markets in which they interact. The three market arenas are:
Goods-and-Services Market Households and the government purchase goods and services from firms in the goods-and-services market. In this market, firms also purchase goods and services from each other. For example, Levi Strauss buys denim from other firms to make its blue jeans. In addition, firms by capital goods from other firms. If General Motors needs new robots on its assembly lines, it may buy them from another firm instead of making them. Firms supply to the goods-and-services market. Households, the government, and firms demand from this market. Finally, the rest of the world both buys from and sells to the goods-and-services market. The United States imports hundreds of billions of dollars worth of automobiles, oil, and other goods. At the same time the United States exports hundreds of billions of dollars worth of computers, airplanes, and agricultural goods. Labor Market Interaction in the labor market takes place when firms and the government purchase labor from households. In this market, households supply labor, and firms and the government demand labor. In the US economy, firms are the largest demanders of labor, although the government is also a substantial employer. The total supply of labor in the country depends on the sum of decisions made by households. Individuals must decide whether to enter the labor force (whether to look for a job at all) and how many hours to work.  Labor is also supplied to and demanded from the rest of the world. The labor market has become an international market. For example, vegetable and fruit farmers in California would find it very difficult to bring their product to market if it were not for the labor of migrant farm workers from Latin America. For years, mass migration has provided Germany with "guest workers" who are willing to take low-paying jobs that more prosperous German workers avoid. Money Market In the money market---sometimes called the financial market---households purchase stocks and bonds from firms. Households supply funds to this market in the expectation of earning income in the form of dividends on stocks and interest on bonds. Households also demand (borrow) funds from this market to finance various purchases. Firms borrow to build new facilities in the hope of earning more in the future. The government borrows by issuing bonds. The rest of the world both borrows from and lends to the money market; every morning there are reports on TV, radio, Internet and print media about the Japanese and British stock markets. Much of the borrowing and lending of households, firms, the government, and the international sector are coordinated by financial institutions---commercial banks, savings and loan associations, insurance companies, and the like. These institutions take deposits from one group and lend them to others. When a firm, a household, or the government borrows to finance a purchase, it has an obligation to pay that loan back, usually at some specified time in the future. Most loans also involve payment of the interest as a fee for the use of the borrowed funds. When a loan is made, the borrower nearly always signs a "promise to repay," or promissory note, and gives it to the lender. When the federal government borrows, it issues "promises" called Treasury bonds, notes, or bills in exchange for money. Corporations issue corporate bonds. A corporate bond might state, for example, "XYZ Corporation agrees to pay $5,000 to the holder of this bond on January 1st, 2022, and interest thereon at 8.3 percent annually until that time." Instead of issuing bonds to raise funds, firms can also issue shares of stock. A share of stock is a financial instrument that gives the holder a share in the firm's ownership and therefore the right to share in the firm's profits. If the firm does well, the value of the stock increases, and the stockholder receives a capital gain on the initial purchase. In addition, the stock may pay dividends---that is, the firm may return some of its profits directly to the stockholders, instead of retaining them to buy capital. If the firm does poorly, so does the stockholder. The capital value of the stock may fall, and dividends may not be paid.  Stocks and bonds are simply contracts, or agreement, between parties. I agree to loan you a certain amount, and you agree to repay me this amount plus something extra at some future date, or I agree to buy part ownership in your firm, and you agree to give me a share of the firm's future profits. A critical variable in the money market is the interest rate. Although we sometimes talk as if there were only one interest rate, there is never just one interest rate at any time. Instead the interest rate on a given loan reflects the length of the loan and the perceived risk to the lender. A business that is just getting started will have to pay a higher rate than will General Motors. A 30-year mortgage has a different interest rate than a 90-day loan. Nevertheless, interest rates tend to move up and down together, and their movement reflects general conditions in the financial market.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 381-384* end |
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