Econ 002 Spring 2017

The Circular Flow

Carol Rogers
Georgetown University

We economists organize our thoughts about how all of the parts of the macro-economy fit together by
using a flowchart that is called the Circular Flow.

This flowchart is extremely useful. It will help you to understand (i) one of the fine points of national
income accounting (comes up on January 19 in this course), (ii) the theory of economic growth (January
31 – February 7), and (iii) how a large national debt affects the economy (February 14 – 28). The Circular
Flow framework also runs in the background of the theory of business cycles that we will conclude the
course with in April.

So let’s get started. I’ll begin with a very simple and mostly hypothetical macro-economy, and then add
more realistic features, until we get a flowchart that could be used to describe the US economy.

The Robinson Crusoe Economy

Robinson Crusoe is the title character of a novel that was published by Daniel Defoe in 1719. This
popular and iconic work is believed to have been based on the experiences of a Scottish privateer
named Alexander Selkirk, who from 1704 until 1709 was stranded in the Juan Fernandez Islands off the
coast of Chile. Economists are as smitten with this story today as Defoe’s readers were in the early 18th
century, although for us the main draw is that the “Robinson Crusoe economy” is a great jumping-off
point for explaining how macro-economies work.

Robinson Crusoe engaged in two main economic activities while on the island, production and
consumption. In economics jargon, he acted as a producer, or “firm,” while foraging every day for food,
and as a consumer, or “household,” while consuming food.

Figure 1 is a flowchart that illustrates Crusoe’s economic activities:

Figure 1: Circular Flow of goods and factors in the Robinson Crusoe economy
Econ 002 Spring 2017

In more complex economies, where households consume many goods (and services) and where there
are numerous factors of production, it is simpler to re-imagine this circular flow as a flow of dollars in
payment for goods (and services) and for the use of factors of production. The flow of dollars goes in
the opposite direction from the flows of goods (and services) and factors in Figure 1: if a household
buys food, the food goes to the household, while the money that pays for the food goes to the firm.
Figure 2, below, shows this alternative way of drawing the Circular Flow. The arrows in Figure 2 are
green, to remind you that they represent a flow of dollars.

Figure 2 highlights something important. All income generated from production gets paid to households.
Households provide the economy’s laborers, and households own all of the other factors of production.

Firms V
Incomes (Y)

Households

Spending (C)

Figure 2: A Robinson-Crusoe economy with money

This is our starting point for developing a working description of the US economy. Now let’s add to this
flowchart.

Saving and Investment

In the Robinson Crusoe economy, Households spend 100% of what they earn. Households in the real
world do not have to do this. They can save some of their income to use for consumption at a later
date. We call this activity Private Saving, and denote it by the letters PS. Remember that households
own the economy’s firms, so PS includes personal saving of households as well as any saving that firms
do on behalf of the households that own them.

As you can tell from the extra arrows in Figure 3 (next page), Private Saving goes to the Financial
Market. Financial Market is a catch-all term for all of the ways that households might save. These
include adding to bank accounts and buying financial assets such as stocks and bonds.
Econ 002 Spring 2017

Y
Firms

Financial Mkt

PS
Investment (I) Households

Figure 3: Saving and Investment in the Circular Flow

The Private Savings that go into the Financial Market are available to be used for Investment.

Brief footnote: Investment is a term of art in Macroeconomics, and has a very specialized meaning that
might not be what you think it is. In Macroeconomics, Investment is the purchase of machinery and
other physical capital that is used to produce output.1 That’s it. Macroeconomists do not use the word
“Investment” to talk about purchases of stocks or bonds or other financial assets.2 This is very different
from the way that people use this word in everyday language, where we hear all of the time about
“investing in the stock market.” So take note: For macro-economists, Investment means purchases of
physical capital. Purchases of financial assets (“investing in the stock market”) are a form of Private
Saving.

Since Investment is the purchase of physical capital, it leads to a payment to capital-producing firms.
We include an arrow in Figure 3 from the Firms box to the outer part of the circular flow, to show that
total spending in the economy now consists of Consumption (C) and Investment (I).

The relationship between Income, Private Saving, Consumption, and Investment that is shown in Figure
3 can also be seen in equations. Remember, the total income that is generated from production is
denoted by Y. This production consists of two types of goods and services, Consumption (C) and
Investment (I). So 𝑌 = 𝐶 + 𝐼. From the household perspective, all income must either be consumed or
saved: that is, 𝑌 ≡ 𝐶 + 𝑃𝑆. The “Y” in these two equations is the same. So we know that

𝐶 + 𝐼 = 𝐶 + 𝑃𝑆
Tidy this up by cancelling out the “C” that appears on each side, and you see that Investment equals
Private Savings:

𝐼 = 𝑃𝑆

1
In many international accounts, physical Investment is called Gross Capital Formation, which is a lot less
confusing.
2
Some people call the purchase of financial assets Financial Investment, but never just Investment.
Econ 002 Spring 2017

We will come back to the simple Circular Flow of Figure 3 in a couple of weeks, as we try to understand
the process of long-run growth. For today’s purposes, though, Figure 3 is too simple: it’s missing some
important features. The next feature that I’ll add to the flowchart is Government.

Government
Government activities lead us to the Circular Flow of Figure 4.

Y
Firms

Financial Mkt

PS
Gov’t Households
I
Net taxes (T)
G
C

Figure 4: The Circular Flow with Government

The circular flow now includes a box that is labelled “Gov’t,” and four new arrows.

One of these arrows is called “Net taxes (T).” Households pay taxes to the government. These Taxes
include personal taxes and taxes on corporations (since firms are owned by households). The
government, in turn, frequently makes transfers to households. Social Security benefits and
unemployment compensation are examples of government transfer payments. “Net taxes” means taxes
minus transfers. In the US in 2015, federal government tax receipts were equal to $3,249.2 billion.
Transfer payments totaled $2,297.2 billion. So in 2015, Net taxes in the US were equal to $3,249.2 -
$2,297.2 = $952 billion. Government transfer payments are typically smaller than tax receipts (as was
the case in the US in 2015), so the net flow of payments between government and households is an
arrow from households to the government.

In future Figures, I’ll denote net taxes by the letter T.

Another new arrow in Figure 4 is the one that is labeled with a G, and which points from the
Government to the outside border of the Circular Flow. This arrow represents government purchases of
goods and services (G). Government pays for these purchases, which leads to a flow of payment to
firms. We now have three sources of demand for goods and services produced by firms: C + I + G.

In recent years in the US, G has been much larger than T, as the US government has run a budget deficit.
For instance, in 2015, G was equal to $1,390.9 billion dollars. That was $438.9 billion greater than T
(which you may recall was $952 billion): the government budget deficit was $438.9 billion.
Econ 002 Spring 2017

The government pays for the excess of spending over net receipts by issuing government bonds. This is
a form of borrowing from the Financial Market. Savers lend the government money in exchange for
bonds. When the bonds come due, the government pays back the money that it borrowed from savers.
In the Circular Flow diagram, we draw a government deficit as an arrow from the financial market to the
government.

Although in the last ten years the US government has run historically large budget, the government
budget was actually in surplus as recently as 2001 (when T exceeded G by $128.2 billion). When the
government has positive savings, we draw this as an arrow from the government to the financial
market.

I drew two arrows going between the government and the financial market in Figure 4. One shows how
the government and the financial market interact when there is a budget deficit, the other shows a
budget surplus. In the interest of avoiding “arrow clutter,” in future versions of this diagram I will just
draw a single double-headed arrow to remind you that the flow of dollars can go either way.

We are almost done. But before we move on to the final amendments to the Circular Flow, let’s see
what adding government to the flowchart has done to the equations for the Circular Flow.

When there is a government, firms produce goods and services for three sectors in the economy
(consumers (C), firms (I), government (G)). The value of this production is income for the households.
So, 𝑌 = 𝐶 + 𝐼 + 𝐺. From the household perspective, the income that households earn will now be split
among three uses: 𝑌 ≡ 𝐶 + 𝑃𝑆 + 𝑇. Comparing these two equations, you can see that

𝐶 + 𝐼 + 𝐺 = 𝐶 + 𝑃𝑆 + 𝑇
𝐼 = 𝑃𝑆 + 𝑇 − 𝐺
In the second of these equations, the expression 𝑇 − 𝐺 is net tax receipts minus spending for
government purchases. This is Government Saving, which we will henceforth denote as GS. GS can be
positive (surplus, as in 1999 -2001 in the US) or negative (deficit, after 2001).3

As you can see, government saving changes the relationship between Investment and Private Saving.
Substitute “GS” for “T – G” in the previous equation, and write:

𝐼 = 𝑃𝑆 + 𝐺𝑆
If there is a deficit (GS < 0), then Investment will be smaller than Private Saving, because some of the
Private Saving is taking the form of households purchasing government bonds.

As one final bit of terminology, the sum of Private Saving and Government Saving is called National
Saving. We use the letter S to stand for this.

3
The negative sign has confused many generations of ECON 002 students. Do not let this happen to you. When
there is a deficit, this means that Government Saving is negative. It is not correct in this case to say that the deficit
is a negative number. The deficit = - GS.
Econ 002 Spring 2017

𝐼 = 𝑃𝑆 + 𝐺𝑆 ≡ 𝑆

Rest of the World

The economy represented in Figure 4 is a “closed” economy, which means that it does not trade with
the rest of the world. It’s time to fix this feature. I’ll be doing this in stages, because this is the part of
the Circular Flow that students seem to find to be the most confusing.

Let’s start by adding a box in the diagram for the Rest of the World (aka, ROW)

The Rest of the World interacts with the circular flow in three ways. First, some of the goods and
services that Consumers (C), Firms (I), and the Government (G) buy are imported goods. It will not be
appropriate to show the payment for this spending going to domestic firms, via that big green arrow
from Households to Firms. We draw imports as a leakage of dollars out of the domestic circular flow, as
shown below in Figure 5. Those payments leave the country. In an equation, we have 𝑌 = 𝐶 + 𝐼 + 𝐺 −
𝐼𝑚𝑝𝑜𝑟𝑡𝑠. Since some of the spending for C, I, and G, did not go to domestic firms, we have to subtract it
out from the total.

imports

Figure 5: Imports

Second, some of the goods and services that domestic firms produce will be sold to the rest of the
world. These are exports. Exports lead to payments to domestic firms, and to income for domestic
Econ 002 Spring 2017

households. In the Circular Flow, we draw an arrow from ROW to the flow of payments to domestic
firms, as in Figure 6. In an equation, we would write 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠.

exports

imports

Figure 6: Imports and exports

To economize on arrows, we will follow the convention of defining net exports (aka the balance of trade)
as exports minus imports. Denote net exports by the letter X. I can replace the two arrows in Figure 6,
with a single double-headed arrow. This is what I did in Figure 7.

When X is positive (exports > imports), we say that there is a trade surplus. In the Circular Flow, there
are more payments coming to domestic firms from ROW than there are payments going in the other
direction. The green “X” arrow would point towards the flow of payments to firms. When X is negative
(exports < imports), then there is a trade deficit, and the arrow points towards ROW.

Figure 7: The complete Circular Flow

Figure 7 also includes an additional double-headed blue arrow running between ROW and the Financial
Market. This third interaction between this economy and the rest of the world is the one that students
often find to be the most surprising. Here’s what that arrow represents.

As you know, when a country runs a trade deficit, the country gets goods that are worth more than the
value of what the country gives up via exports. Imports > exports (X < 0). The only way this is possible is
if the rest of the world is willing to accept US dollars as a kind of IOU. In the future, ROW will be able to
Econ 002 Spring 2017

get more goods from the US than it gives up to the US. So when the US runs a trade deficit, ROW is
lending to the US.

For some additional insight about this, start by contemplating what ROW does with the excess dollars
that it accumulates via US trade deficits.4 That is, what does ROW do while waiting for that future time
when it will buy more goods from the US than it gives up? ROW holders of dollars will want to earn
some return on those holdings. A way to do this is to purchase dollar-denominated financial assets. This
brings funding to the US financial market!

A lot of these financial assets are US government bonds. The table below shows foreign holdings of US
government bonds as of October 2016. The top two holders of this debt are Japan and China, with
Ireland in a very distant 3rd place.

Country Holdings of US Treasury securities (bonds)

Japan $1.13 trillion
China $1.11 trillion
Ireland $0.27 trillion
Source: US Treasury, http://ticdata.treasury.gov/Publish/mfh.txtsome

These financial flows put trade deficits in a light that you may not be accustomed to thinking about.

“Deficit” is not normally a word with a positive connotation, and it is easy to fall into the trap of thinking
that trade deficits are intrinsically bad. But there is one important sense in which the large US trade
deficit really helps us out. If not for the fact that Japan and China are lending so much to the US
government, our large federal budget deficit would be soaking up our own Private Savings, significantly
reducing the amount of lending that is available for Investment in the US. The phrase “another big
recession” is coming to mind.

In terms of the Circular Flow of Figure 7, here is the conclusion that has surprised so many of my
students over the years:

When a country runs a trade deficit (X is negative: the green “X” arrow points towards ROW), the
blue arrow points towards the Financial Market.

To be complete, I should point out that under a US trade surplus, the blue arrow in Figure 7 would point
towards ROW, while the green arrow would point towards the US. The US would be financing ROW’s
trade deficit. Today’s lecture slides showed both of these cases separately.

4
This will help you to see why ROW is willing to take US dollars.
Econ 002 Spring 2017

Well, that was exciting to write about. But now let me calm down a bit by expressing the complete
Circular Flow relationships in equations. With ROW in the picture, 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋. But it is still the
case that 𝑌 ≡ 𝐶 + 𝑆 + 𝑇. We have

𝐶+𝐼+𝐺+𝑋 = 𝐶+𝑆+𝑇

𝐼+𝐺+𝑋 = 𝑆+𝑇
With a little bit of extra maneuvering, this equation can be written as

𝐼 + 𝑋 = 𝑃𝑆 + 𝐺𝑆 ≡ 𝑆
This is just what I said before. Ignoring X, if GS < 0 then Investment will be smaller than Private Saving.
That’s because some of Private Saving will take the form of purchases of government bonds, leaving less
available for lending to firms. However, if X < 0, then lending from abroad can help finance the
government budget deficit, leaving more funding available for Investment.

In case it seems like you are having to learn a lot of equations, I have good news. The only ones that you
have to learn are the last ones, because all of the other relationships are special cases of those. So for
instance, look at the equation
𝐼 + 𝑋 = 𝑃𝑆 + 𝐺𝑆 ≡ 𝑆
If there is no ROW, then 𝑋 ≡ 0, so this becomes 𝐼 = 𝑃𝑆 + 𝐺𝑆 ≡ 𝑆. If there is no government, then
there is no government saving, so 𝐼 = 𝑃𝑆 ≡ 𝑆.

Today’s lecture slides finished up with a Circular Flow graph that was labeled with the latest (2016:III)
figures from the US. I won’t repeat it here, but be sure to have another look at it.