Wednesday, September 22, 2010

Lessons in Macro Economics - Closed Economy Circular Flow Diagram

This graph represents a more realistic model of the economy as compared to the earlier model that only included households and firms. The green arrows represent how money moves between economic actors (red boxes) through different markets in the economy (orange boxes.)

Households receive income from supplying their labor. They use this money to save money in financial markets (banks, etc), pay taxes to the government, and consume goods and services from the private sector.

Firms take payments from households and government purchases in order to produce goods and services. They also have to pay households for their labor and the rest is reinvested through financial markets.

Governments collect taxes from households and make capital outlays, which benefit society in the form of infrastructure, schools, public safety, etc. Whatever is left over gets reinvested through financial markets.

This is still a simplistic model, but it helps to understand how various sectors of the economy work together to produce its Gross Domestic Product. Our model does not yet include imports and exports in foreign markets, which we'll get to later.

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