1.2 Putting the Categories Together

1.2 Putting the Categories Together

Now that we have the categories from 1.1, we can put them together to get a complete picture of flows in a closed economy.

A. A very simple economy
Suppose that all income is spent on goods and services.

We show a clockwise flow of spending represented by our green pipe. Not a very exciting economy. But note that Consumption, as defined on the right side -- a use of income -- must be exactly the same amount as consumption on the left side, understood as a source of demand for output. Consumption (C) is the only place for output (Y) to go, so C = Y. And since all income is spent on consumption, Y = C. We can summarize the two sides of the picture as:

C = Y = C

B. The very simple economy plus government
Let's add a government that has only one way to fund its activity -- taxes -- and which spends all tax revenues to buy goods and services.

Again we have a clockwise flow of spending, but now we have two pipes, with a smaller stream being diverted through government. There are two things that can happen to income, so that Y = T + C. And there are two places goods can go to, so Y = C + G. Put it all together, and we can describe the picture as

C + G = Y = T + C

C. The very simple economy plus saving and investment
Let's abolish government again, just for a minute, and look at the very simple economy with saving and investment.

Here we have some income being diverted from consumption into saving, and that saving funds a corresponding stream of capital investment -- demand for capital goods. Let's look for a minute at that financial sector. When we added in government, above, we didn't have to say much about it because taxes are an involuntary payment. But saving is voluntary, so savers must be getting something in exchange. What they are getting are new financial assets of various kinds. A simple way to run a financial sector is as a market in IOUs -- savers purchase IOUs, or promises to make future payments. The sellers of IOUs, or borrowers, need money now to buy capital goods. They hope that they can operate the capital goods profitably enough to pay off the IOUs.

We can describe the picture above as

C + I = Y = S + C

showing that good can end up either as C ro I, and that incomes go into S or C.

D. The basic closed economy framework; fiscal surpluses and deficits
Now we can bring back government and assemble the whole framework:

Moving clockwise from the top, we see how income is used: first, income divides into taxes and disposable income. Then disposable income goes either to consumption or saving. Moving counter-clockwise from the top, we see that the goods whose sales produced income end up with either consumers, businesses, or government.

But wait! Government can also interact with the financial sector as a borrower or lender. If it's a net borrower, we have a fiscal deficit, in which G > T.

Note the flow from the financial sector to government. This means that government, just like businesses, is borrowing from svers by selling IOUs.

If we have a fiscal surplus:

in which T > G, government joins savers in purchasing IOUs issued by businesses.

If G > T then S > I, and in the same amount, right? And if T > G then I > S, and in the same amount. We can summarize by saying that

C + I + G = Y = T + S + C

and since C = C, this implies that

I + G = T + S

In other words, these two flows:	must add up to the same amount as these two flows:

Hopefully, by now this all seems really obvious. But pause a moment and reflect that we have shown that the activities represented by the letters C, I, G, S, and T -- five quite different things, done for different reasons and often by different people -- are in fact very tightly related to each other. By just looking at the flows you can see, for example, that if we raise government purchase without raising taxes, and if household savings does not change, then capital investment must fall.