Introduction

In 1946 the economist AW Phillips (who invented the Phillips Curve) constructed a huge model of the British economy out of pipes and tubes called the Moniac. It was the first attempt to represent the flows of money which drive the macroeconomy.

The Circular Flow

Money flows around our economy financing transactions. But the money flows can be represented in two ways. Some money flows purchase goods and services, and we call these injections (J). Others are flows into savings – for example a bank account, or flows to overseas firms to pay for imports. We call these flows withdrawals.

Below is a four sector economy – a simple representation of how these flows of money operate.

 

The Four Sectors

The Household Sector

The Household sector earns wages (Y) to form its income and then saves some of this income (Y), pays some in taxation (T), and spends the rest on consumer spending (C). In total spending in the UK economy consumer spending forms two-thirds – and so a small change in spending patterns has a big effect on UK economic activity and output (real GDP).

Y = C + S + T

The Company Sector

Firms pay out factor incomes – wages to their workers and profit to their shareholders in the form of dividends. They also borrow money from the banking system to spend on investment – the purchase of capital equipment or buildings. So wages flow out of the company sector and investment funds flow in to the sector.

The Banking Sector

Banks recycle savings. When we put money in to the bank, we earn a rate of interest on our savings – currently around 1% or 2% depending on the form of savings account. The Bank then lends the money out on mortgages or to companies in loans for which it charges a rate of interest (currently between 6% and 11% depending on the size of loan and the risk involved).

The difference between the savings rate and the lending rate is called the spread. Banks make their money on this spread – in 2015 the spread is large (between 5% and 9%).

The Overseas Sector

The UK trades with the rest of the world – Europe for example takes 55% of our exports. In one month, July 2015, UK imports exceeded exports by £10bn – this represents a net outflow from the circular flow. Money is flowing across the exchange rates and leaving the UK banking system to find its way into foreign bank accounts.

Does this trade imbalance matter? How do we finance it? These are key questions to consider in the course on macroeconomics.

The Government Sector

The UK Government takes our money in taxes – such as income tax and VAT and then spends it on goods, services, wages and investment of its own. When the Government builds a motorway this is pubic sector investment. When the Government pays a teacher, this is a payment in wages, which is called current spending.

Taxation (T) is a withdrawal from the circular flow and Government spending (G) of any kind is an injection.

(G – T) gives us a public sector net deficit or surplus. We use a shorthand and call the Public Sector Debt Requirement the PSDR. In 2014 the PSDR stood at £85bn compared with the peak year (2010) at over £150bn. Public sector debt currently stands at 80% of GDP – high by international standards. This debt is the accumulation of all past annual deficits less any surpluses. In this financial year the(April 2015 to April 2016) the deficit is expected to be £67bn.

Does this high debt to GDP ratio matter? Is the Government correct to put deficit reduction top of its list of priorities (together with stable prices)?

The idea of equilibrium

If the economy is in macroeconomic equilibrium, then total withdrawals must equal total injections. Or

S +T + M = I + G + X

For economic growth to occur injections must exceed withdrawals. It doesn’t matter which injection is doing the work – exports, investment or Government Spending. And we have already said that consumer spending is the engine of growth – as consumers spend more their withdrawal of savings will go down. So consumer activity is implicit in tis condition of W=J.

The Aggregate Demand Equation

Another way of describing the key elements of the circular flow is by the aggregate demand equation, which we discuss further as key concept 2.

AD = C + I + G + (X – M)

Notice this is the same thing as the W = J condition.

AD = AE = AY

Y = C + S + T

By substitution,

C + S + T = C + I + G + (X – M)

The two Cs cancel each other out on each side of my above identity so

(S + T) = (I + G) + (X – M)

We can re-arrange this in the following way so that the public sector deficit or surplus (G – T) and the trade deficit or surplus (X – M) are on the right hand side:

(S – I) = (G – T) + (X – M)

More Advanced – The significance of Sector Balances

Finally, the two sides of the equation must equal each other when the UK economy is in equilibrium. So a more advanced and subtler idea is to say the sector balances must together add to zero.

Rearranging the W = J condition:

S + T + M = I + G + X

(S – I)  = (G – T) + (X – M)

If the public sector deficit is – £67bn, G is greater than T by 67, and the current account deficit is £98bn, so

(- 38) = (67) + (- 98)

We conclude that investment must be greater than Savings by £31bn in 2015. In 2014 GDFCF (Gross Domestic Fixed Capital Formation – the standard measure of Uk investment) was £293bn and private sector Savings stood at £262bn for that year.

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G – T < 0) coincide, there must be a private household deficit. While private spending can persist for a time under conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.

A moment’s thought leads us to this conclusion: the present austerity policy (reduction of the public sector deficit as a prime objective of macro policy) is also aimed at bringing private sector savings and investment into closer alignment – or to put it another way, it is aimed at reducing private sector indebtedness and rebalancing the relation between consumption (C) and saving (S).