1.2 Module 10: The Circular-Flow Diagram and the National Accounts

The National Accounts

Almost all countries calculate a set of numbers known as the national income and product accounts. In fact, the accuracy of a country’s accounts is a remarkably reliable indicator of its state of economic development—in general, the more reliable the accounts, the more economically advanced the country. When international economic agencies seek to help a less developed country, typically the first order of business is to send a team of experts to audit and improve the country’s accounts.

In the United States, these numbers are calculated by the Bureau of Economic Analysis (BEA), a division of the U.S. government’s Department of Commerce. The national income and product accounts, often referred to simply as the national accounts, keep track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money among different sectors of the economy. Let’s see how they work.

The Circular-Flow Diagram

To understand the principles behind the national accounts, it helps to look at a graphic called a circular-flow diagram. Some of you have already encountered a version of this diagram in your study of microeconomics.

The circular-flow diagram is a simplified representation of the economy that shows the flows of money, goods and services, and factors of production through the economy. It allows us to visualize the key concepts behind the national accounts. The underlying principle is that the flow of money into each market or sector is equal to the flow of money coming out of that market or sector.

The Simple Circular-Flow Diagram

The U.S. economy is incredibly complex, with more than a hundred million workers employed by millions of companies, producing millions of different goods and services. Yet you can learn some very important things about the economy by considering Figure 10-1. This simple diagram represents the transactions that take place by two kinds of flows around a circle: flows of physical things such as goods, services, labor, or raw materials in one direction, and flows of money that pay for these things in the opposite direction. In this case, the physical flows are shown in yellow, the money flows in green.

The simplest circular-flow diagram illustrates an economy that contains only two kinds of “inhabitants”: households and firms. A household consists of either an individual or a group of people who share their income. A firm is an organization that produces goods and services for sale—and that employs members of households.

As you can see in Figure 10-1, there are two kinds of markets in this simple economy. On one side (here the left side) there are markets for goods and services (also known as product markets) in which households buy the goods and services they want from firms. This produces a flow of goods and services to the households and a return flow of money to firms.

On the other side (at right) there are factor markets in which firms buy the resources they need to produce goods and services. The best known factor market is the labor market, in which workers are paid for their time. Besides labor, we can think of households as owning and selling the other factors of production to firms.

This simple circular-flow diagram omits a number of real-world complications in the interest of simplicity. It does not offer a complete picture of participants in the economy and the flows that take place among them. But, it is a useful aid to thinking about the economy. And, we will use the simple diagram as the starting point for developing a more realistic (and therefore more detailed and complicated) circular-flow diagram.

The Expanded Circular-Flow Diagram

Figure 10-2 is a revised and expanded circular-flow diagram. This diagram shows only the flows of money in the economy, but is expanded to include extra elements that were ignored in the interest of simplicity in the simple circular-flow diagram. The underlying principle that the inflow of money into each market or sector must equal the outflow of money coming from that market or sector still applies in this diagram.

A circular flow of funds connects the four sectors of the economy—households, firms, government, and the rest of the world—via three types of markets: the factor markets, the markets for goods and services, and the financial markets.

• Funds flow from firms to households in the form of wages, profit, interest, and rent through the factor markets. After paying taxes to the government and receiving government transfers, households allocate the remaining income—disposable income—to private savings and consumer spending.
• Via the financial markets, private savings and funds from the rest of the world are channeled into investment spending by firms, government borrowing, foreign borrowing and lending, and foreign transactions of stocks.
• In turn, funds flow from the government and households to firms to pay for purchases of goods and services.
• Finally, exports to the rest of the world generate a flow of funds into the economy and imports lead to a flow of funds out of the economy.

If we add up consumer spending on goods and services, investment spending by firms, government purchases of goods and services, and exports, then subtract the value of imports, the total flow of funds represented by this calculation is total spending on final goods and services produced in the United States. Equivalently, it’s the value of all the final goods and services produced in the United States—that is, the gross domestic product of the economy.

In Figure 10-2, the circular flow of money between households and firms illustrated in Figure 10-1 remains. In the product markets, households engage in consumer spending, buying goods and services from domestic firms and from firms in the rest of the world. Households also own factors of production—land, labor, and capital. They sell the use of these factors of production to firms, receiving rent, wages, and interest payments in return. Firms buy, and pay households for, the use of those factors of production in factor markets, represented to the right of center in the diagram. Most households derive the bulk of their income from wages earned by selling labor.

Some households derive additional income from their indirect ownership of the physical capital used by firms, mainly in the form of stocks—shares in the ownership of a company—and bonds—loans to firms in the form of an IOU that pays interest. In other words, the income households receive from the factor markets includes profit distributed to company shareholders and the interest payments on any bonds that they hold. Households also receive rent from firms in exchange for the use of land or structures that the households own. So in factor markets, households receive income in the form of wages, profit, interest, and rent via factor markets.

Households spend most of the income received from factors of production on goods and services. However, in Figure 10-2 we see two reasons why the markets for goods and services don’t in fact absorb all of a household’s income. First, households don’t get to keep all the income they receive via the factor markets. They must pay part of their income to the government in the form of taxes, such as income taxes and sales taxes. In addition, some households receive government transfers—payments that the government makes to individuals without expecting a good or service in return. Unemployment insurance payments are one example of a government transfer. The total income households have left after paying taxes and receiving government transfers is disposable income.

Because the markets for goods and services do not absorb all household income, many households set aside a portion of their income for private savings. These private savings go into financial markets where individuals, banks, and other institutions buy and sell stocks and bonds as well as make loans. As Figure 10-2 shows, the financial markets (on the far right of the circular flow diagram) also receive funds from the rest of the world and provide funds to the government, to firms, and to the rest of the world.

Before going further, we can use the box representing households to illustrate an important general characteristic of the circular-flow diagram: the total sum of flows of money out of a given box is equal to the total sum of flows of money into that box. It’s simply a matter of accounting: what goes in must come out. So, for example, the total flow of money out of households—the sum of taxes paid, consumer spending, and private savings—must equal the total flow of money into households—the sum of wages, profit, interest, rent, and government transfers.

Now let’s look at the other inhabitants in the circular-flow diagram, including the government and the rest of the world. The government returns a portion of the money it collects from taxes to households in the form of government transfers. However, it uses much of its tax revenue, plus additional funds borrowed in the financial markets through government borrowing, to buy goods and services. Government purchases of goods and services, the total of purchases made by federal, state, and local governments, includes everything from military spending on ammunition to your local public school’s spending on chalk, erasers, and teacher salaries.

The rest of the world participates in the U.S. economy in three ways. First, some of the goods and services produced in the United States are sold to residents of other countries. For example, more than half of America’s annual wheat and cotton crops are sold abroad. Goods and services sold to other countries are known as exports. Export sales lead to a flow of funds from the rest of the world into the United States to pay for them.

Second, some of the goods and services purchased by residents of the United States are produced abroad. For example, many consumer goods are now made in China. Goods and services purchased from residents of other countries are known as imports. Import purchases lead to a flow of funds out of the United States to pay for them.

Third, foreigners can participate in U.S. financial markets. Foreign lending—lending by foreigners to borrowers in the United States and purchases by foreigners of shares of stock in American companies—generates a flow of funds into the United States from the rest of the world. Conversely, foreign borrowing—borrowing by foreigners from U.S. lenders and purchases by Americans of stock in foreign companies—leads to a flow of funds out of the United States to the rest of the world.

Note that like households, firms also buy goods and services in our economy. An automobile company that is building a new factory will buy investment goods—machinery like stamping presses and welding robots—from companies that manufacture these items. It will also accumulate an inventory of finished cars in preparation for shipment to dealers. Inventories, then, are goods and raw materials that firms hold to facilitate their operations. The national accounts this investment spending—spending on new productive physical capital, such as machinery and buildings, and on changes in inventories—as part of total spending on goods and services.

You might ask why changes in inventories are included in investment spending—finished cars aren’t, after all, used to produce more cars. Changes in inventories of finished goods are counted as investment spending because, like machinery, they change the ability of a firm to make future sales. So spending on additions to inventories is a form of investment spending by a firm. Conversely, a drawing-down of inventories is counted as a fall in investment spending because it leads to lower future sales.

It’s also important to understand that investment spending includes spending on the construction of any structure, regardless of whether it is an assembly plant or a new house. Why include the construction of homes? Because, like a plant, a new house produces a future stream of output—housing services for its occupants.

Suppose we add up consumer spending on goods and services, investment spending, government purchases of goods and services, and the value of exports, then subtract the value of imports. This gives us a measure of the overall market value of the goods and services the economy produces. That measure has a name: it’s a country’s gross domestic product, which is the topic of the next module.

Module 10 Review

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