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Macroeconomic Concepts and ApplicationsPaying attention to basic relationships through circular flow analysis

Paper for ATEC 2010, University of Waikato, Hamilton

Keith Rankin

Dept. of Accounting and Finance

Unitec New Zealand (Auckland)

28 June 2010

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Circular Flow Model• Quesnay's Tableau Economique 1758

– Dr Quesnay drew on analogy to Circulatory System from William Harvey's "On The Motion of The Heart and Blood in Animals", 1628"

• Keynesian macroeconomics emphasises quantitative flow models over price-adjustment models– integrates financial and current flows– genesis of National Accounting

• "Hydraulic Keynesianism" (Alex Millmow): 1950s– reference to Bill Phillips, who started his professional life in New

Zealand as a hydraulic engineer, and went on to a career in economics at the LSE where he built a famous machine (MONIAC) to demonstrate the circular flow relationships in a nation's economy

– Phillips also published the paper that led to the "Phillips Curve"

Global Approach

• Circular Flow analysis is most powerful as a tool to investigate closed economies

• The most important closed economy by far is the global economy– analysis is relatively simple because governments are like big

households, and there's no foreign sector– most sensible starting point for a study of macroeconomics– lends itself to an easy conflation of circular flow and balance of

payments analysis

• Financial flows in both directions– net financial flow may be in either direction– normally finance flows from households to firms

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Introductory Presentation

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Households / Consumers

Firms / Producers

Financial Intermediaries

(eg Banks)

Figure 1

Income

Consumer Spending

Saving Investment

Simple Global Circular Flow Diagram

Balance of Payments• Flows are Money flows

– spending offset by goods and services in opposite direction

• Figure 1 can easily be re-presented as a Balance of Payments circular flow– "Households" become 'Creditor Countries'– "Firms" become 'Debtor Countries'– "Consumer Spending" becomes 'Net Imports'– "Income" becomes 'International Investment Income'

• "Current Account": International Investment Income – Net Imports

– Financial flows ("Saving" and "Investment") become the 'Capital/Financial Account'

• Balance of Payments: Current Account + Capital/Financial Account© Unitec New Zealand

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source: Stewart and Rankin (2008) p.200

Traditional National Economy Representation

Figure 2

Bias in the Traditional Representation• Taxation

– represented as being paid from income that has become the property of households

– alternative representation is that direct taxation takes place 'at source', representing an innate public property right, meaning that taxed income is not an appropriation of private income

• from this representation income is divided three ways at source:– to labour as wages and salaries– to shareholders and creditors as dividends and interest– to the 'Crown' as taxes or royalties

– benefits are represented as "transfers" (aka "hand-outs")• as public revenue derives from a property right, then at least some

benefits should be dividends rather than transfers

• case of New Zealand Superannuation© Unitec New Zealand

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Saving and Investment

• Investment is a net quantum:– externally financed spending on capital goods (+)– repayments of loans (-)– company saving (-)– internally financed spending on capital goods (+)

• Saving is a net quantum– household income not spent (+) [purchase of financial assets]– withdrawals of past saving (-) [sale of financial assets]– consumer/household finance (-)

• note finance to purchase 2nd-hand houses represents spending or saving by the house vendor

– repayments of consumer/household finance (+)© Unitec New Zealand

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Critical Conceptual Issues• What happens when net saving is positive and net

investment is negative?– unplanned inventory investment leading to reverse multiplier?– deflation? (may have a positive feedback effect on net saving)– consumer finance?

• What happens when net saving is negative and net investment is positive?

• How does consumer finance fit into the bigger picture?– marketing of bank loans to households represents an alternative to a

reverse multiplier driven by unplanned investment– financial initiatives may pre-empt the multiplier and/or deflationary

adjustment processes that would otherwise take place

• What happens when retirement savings funds are spent? © Unitec New Zealand9

Implications for Teaching Macroeconomics• Books needed [eg Moss (2007) ] to explain:

– "what managers, executives and students" need to know about the basic relationships

• especially the relationships that represent the interaction between financial markets and goods/services markets

• that financial flows are two-way

– economic textbooks do not explain these relationships well, in part because AD/AS approaches do not require such explanation

• Underlying "Mercantilism" in students' (and graduates') thinking about economic issues– selling is better than buying [exporting better than importing]– market competition is of a win-lose, not a win-win, variety– wealth is the acquisition of claims on output rather than output itself– creditor nations and surplus nations are conceptually the same thing© Unitec New Zealand

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