This is the first of the three courses part of the Globalization, Economic Growth and Stability Specialization. This course will employ a non-technical approach to analyze how governments use policy to influence a country's economy. Upon completing the course you should be able to discuss national debts and deficits, examine fiscal and monetary policy and their appropriateness to the situation of an economy, and anticipate the results of fiscal and monetary policies and structural reform on a country. These concepts will give you the tools to develop your own position in many current economic debates, such as fiscal stimulus vs. austerity, the merits of quantitative easing, the need for higher interest rates or the future growth path of many modern economies.
What is GDP - The Circular Flow Diagram
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Do curso por IE Business School
Understanding economic policymaking
616 classificações
IE Business School
616 classificações
Curso 1 de 3 em Specialization Globalization, Economic Growth and Stability
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Macroeconomy Overview
We are surrounded by news and commentary on the macroeconomy. To understand it, we need to grasp the meaning of GDP, inflation and unemployment and see what their “normal” levels are and how they relate to one another. Though these levels and relationships are far from mechanical, they provide an essential foundation to understanding what governments are doing in a macroeconomy.
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Gayle AllardProfessor
Economics
[MUSIC]
In order to understand economic policymaking,
we have to start back with the
basic indicators, the basic numbers that
tell us what's happening in a macroeconomy.
Now you have to remember that a country's economy,
a macroeconomy, is a dynamic, vibrant, immensely complex organism.
It's moving all the time, it's not stable, and so we're going to concentrate in these
first few minutes on three indicators that you
surely have studied elsewhere in a different course.
But, just to make sure that we understand them
and the relationships among them, so that we can talk
about what government should do when they look at
the economy, and when they try to correct the problem.
So, we're going to start with the,
something we call the circular flow diagram
to understand what GDP is, and also to see the dynamics of a macroeconomy.
So we, the first picture we're going to make
here is of a, an economy, that's very simple.
It's got just households on one side.
It's got businesses on the other side.
And we have a relationship between the two of them,
which is the households buy goods and services from businesses.
And the businesses then pay income to households,
in the form of wages, interest, rent whatever.
Now, what households buy from businesses, is
something we called consumption, and this is the
biggest part of GDP, it's very stable what people tend to buy in order to
live; it's not going to fluctuate a lot over time And, so if you look at
this diagram and you think about that top
arrow, which is the expenditures in the economy.
So far, it's just consumption.
That top arrow and its relationship with the bottom arrow, which is income in
the economy, what you realize is that they're going to tend to be equal.
In other words, if people are consuming 100, the businesses will then have 100 to
pay back to the households in the form of profits, wages, interest, rents, whatever.
But if people receive 100 and suddenly start to consume only 90, what's going to
happen is that the next round, businesses will have only 90 to generate an income.
So the whole economy will shrink.
In other words, the idea is that the top arrows are spending,
and whatever is spent will determine those bottom arrows, which are income.
And the two will tend towards equality.
It's an important thing for us to remember, because this is dynamic, right?
And the top part is determining the bottom part.
So, after people receive their income, we've seen that they consume.
But something else they might do with their income is, they might save it.
Okay, so we have an arrow coming out of here and that's savings.
And it goes into the financial sector, which is a box up here.
And once it's in the financial sector, it may
come back into spending again in the form of investment.
Okay?
Now something we need to understand is that it's
one group of people that does the saving, and
another group of people that does the investing, so
there's no reason for those two to be equal.
In other words, I might be saving money because I'm thinking about my future.
I'm thinking about getting my children through the university.
I'm thinking about my pension, my house I want to buy.
And investors might go and borrow the money I saved.
Because they want to build a new building, because
they think that the future is going to be really bright.
or, they might [UNKNOWN] not want to
borrow the money I saved, because they don't
think the future looks very good, for the same reason I want to save a lot.
So, there's a possibility that savings will be bigger than investment.
Or, investment will be bigger than savings.
All right.
If this happens, I want you to just think
for a minute, what is the effect on the economy?
Imagine that we've got 100 on that bottom
flow, 100 in income, and households receive it.
They spend 90, and they save ten.
Okay?
So ten goes into the financial system.
All right?
Now imagine that investors go to the financial system
and they want to borrow only five of that ten.
Okay, so we've got ten going out and only five coming back in.
This will cause the economy to shrink.
In fact, we talk about, in the economy we talk about things that are injections,
which is money that comes out of
the income stream, and joins expenditure, all right?
And then we have things that we call leakages.
And that's money that was in that income stream and it leaves.
So in this picture we're just drawing, a leakage is savings.
Alright, it was generated, it went into household's pockets,
and they took it out of the income stream.
All right, and the injection is investment.
This is money that is out of the system, it's in the
financial sector, and investors go and get it, bring it back in.
All right?
So that's an injection, and what you realize if you think about this is,
the economy will be stable at the place where injections equal leakages.
All right?
Now if leakages, savings in this case, are bigger than injections, which
is investment, you can see that the economy is going to decline.
All right?
We took out 10 and only 5 come back in.
The economy will decline.
And in this respect, it's important to think about the financial crisis.
What happened when the financial crisis started?
Well, people became very afraid because they realized that their
house wasn't worth what they thought it was, that their mortgage
was a lot bigger than they thought it was, relative to
the value of their house, that they might lose their job.
They started saving more, leakages grew.
At the same time, investors looked at the future and they said, Wow.
This doesn't look good.
I don't want to build that new factory, because I don't know
if I'm going to sell what I would produce in it next year.
So they started investing less.
Okay?
So the leakage became greater.
The injection became smaller.
The economy went straight down.
Okay, and that's the beginning of the financial crisis.
Now, there are some other things that happened in the economy.
Just to go through them briefly, besides saving some of our
money, we also pay taxes with some of it, all right?
In fact, we pay taxes every place in this circular flow.
We pay taxes when we get our money,
while we're spending our money, businesses pay, right?
All kinds of taxes coming out, and these flow into the public sector, all right?
And, the public sector then puts the money back in, in the ter, in the form
of government spending, or in the form of
transfer payments to people: unemployment benefits, pensions and whatever.
So, you see that we have a new leakage, which
is tax, and a new injection, which is government spending.
And again, now when we put all these together, we see that [COUGH]
all leakages will need to equal all injections for the economy to be stable.
All right?
If all leakages are bigger than all injections, in
other words, if savings and tax together are taking
more out of the economy than government spending and
investment are bringing in, the economy will shrink, all right?
If all injections are bigger than all leakages,
so investment plus government spending together are bigger.
They're putting more into the economy than what savings and tax are taking out.
The economy will grow.
So again, going back to the financial crisis, we saw that in the first
phase, in the first moment of the crisis, people began to save more, invest less.
Okay, bigger leakages, smaller injections.
How could the government offset this?
This is our first insight onto the government.
How could the government offset this?
By spending more and taxing less.
And that is in fact what the U.S. Government
did in the first moment after the crisis started.
So a new, a new bigger injection to compensate for smaller investment.
A smaller leakage to compensate for bigger savings.
This should have done the trick.
All right?
Now there's one other thing that happens in the economy, just to understand
the whole picture of GDP, and that is, that we trade with foreign countries.
So, we've got a foreign sector out there, and we import from
them, which takes some of our income and puts it in foreign countries.
That's a leakage.
And we export to them, which takes some of their income
and shoots it into our expenditure stream, that's an injection, okay?
So if you look at this picture, you can see that
one way for countries to come out of this crisis would
be for this new injection we've just added, exports, to be
very big, relative to the new leakage we've added, which is imports.
Okay, so if a country manages to export a lot
more than it imports, it can compensate for the extra
savings that happened as the financial crisis hit, or for
the low investment that happened as the financial crisis hit.
Or, if you think of a country like Spain, which had savings going up, investment
going down, government spending going down, taxes going up.
So, leakage is way up, injection is way down.
The only way a country like Spain could compensate for
the downward effect that this exercises on the economy would
be to export much more than it imports, and try
to get some growth, and that's exactly what it's doing.
So, this picture of the circular flow helps us to understand what GDP is.
GDP is actually the top part of this flow in the analysis we're doing today.
The top part of this flow, all of the spending in the economy.
If you look at all of the arrows we've drawn, we've got consumption, investment,
government spending, and net exports, or exports minus imports.
In other words, we have a GDP equation C plus I plus G plus X minus M.
The way to express this in, in words is that GDP is the total market
value of all final goods and services produced in the economy in a given year.
We add all of this up, all of our spending,
on the things produced by the economy, and we get GDP.
Now there are two other indicators that we need to talk
about, and they're not the topic of this course, and so
I just want to mention their definitions, because I'll be referring
to them all the time in later episodes of this course.
We're going to be interested in inflation.
Inflation simply measures the increase, and sometimes the
decrease, the increase in the prices of a basket of goods that the normal
consumer buys, and we usually talk about how much those prices
have gone up or have gone down in the last year.
Unemployment is the percent of the labor force
that is looking for work and can't find it.
Okay?
The percent of all of those who are either working or looking
for work who cannot find work even though they're searching for it actively.
So those are the three big indicators we're going to
be talking about in this first session, and in later sessions.
GDP, inflation, and unemployment.
What we're going to do next is try to figure out
what the right levels are, and how they interact with each other.
[MUSIC]
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