Southeast Missouri State University

Elementary Macroeconomics

Peter M. Kerr

Cape Girardeau, Missouri

Table of Contents

Chapter Page

1. Stocks and Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A. Introduction

B. Stocks and Flows

C. Saving versus Savings

D. Deficits and Debt

2. Circular Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. Real Flows

B. Yardstick of Value

C. Equilibrium

D. The Market for Loan Funds

3. Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. Surpluses and Deficits

B. Accommodative Monetary Policy

4. Foreign Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. Purchases of Imports

B. Sales of Exports

C. Foreign Exchange

Chapter 1. Stocks and Flows

A. Introduction

Spawned by the Great Depression of the 1930’s, John Maynard Keynes’ General Theory created a schism in the body of economic theory which has yet to be reconciled among the practitioners. The theory that existed prior to Keynes became known as microeconomics. Its focus is limited to the study of individual markets, e.g., the market for automobiles or the market for cedar pencils. Microeconomics studies consumer demand for automobiles or, alternatively, the demand for Chevrolets or, alternatively, the demand for used Chevys. On the other hand, the tools of microeconomics could be brought to bear on the automobile industry’s demand for steel or Chrysler’s demand for machinists.

The quagmire of the Great Depression prompted Keynes to question some of the premises of economics (thereafter microeconomics). He suggested that economics suffered from the fallacy of composition in its assuming that what was true for a part was also true for the whole. For example, consider a football stadium filled to capacity viewing a hotly contested battle between two rival schools on a sunny fall afternoon. Early in the third quarter of the game, a given individual (a part) may be able to exit the stadium and get to his car within five minutes. Once the final gun sounds, could it safely be assumed that the capacity crowd (the whole) could vacate the stadium in five minutes? Of course not, and to assume so would be to fall victim to the fallacy of composition. In the realm of economics, all economists (including Keynes) would argue that an individual saving and accumulating wealth is admirable or, at least, not harmful. In his new theory, Keynes argued that if everyone saved, it could have a deleterious effect on the economy as a whole. This new theory, as introduced in his seminal work The General Theory, gave birth to macroeconomics.

B. Stocks and Flows

Before introducing the basic framework of macroeconomics, a distinction must be made between stock and flow variables. A stock variable is the measure or value of a variable at a point in time; a flow variable is the measure or value of a variable over a period of time.

Courtesy of Texas to Montana Cattle Drive

Consider the cattle drives of the Old West. At the end of the drive, the cattle would be herded through town to the railhead. Shopkeepers, anticipating a jump in sales to cowboys coming off the trail, would count the steers as they rumbled by. Yet, just as we grow tired of trying to count the number of cars in a train that has held us up at a railroad crossing, so too might these merchants tire. Past experience and their own parsimony may prompt these businessmen to develop a way to estimate the size of the herd. For example, they may concentrate on counting the number of cattle that pass by in a minute’s time and then multiply this number by the number of minutes for the entire herd to pass. Suppose one shopkeeper counts 25 steers in one minute and he notes that it took 20 minutes for the entire herd to pass by his store. His estimate of the herd’s size would be 500 steers.

25 steers × 20 minutes = 500 steers

1 minute

a flow or × time = a stock

rate

He could verify his estimation technique by moseying down to the stockyard and asking its manager how many steers were just taken in. Or, with patience, he might be able to count the 500 or so steers in the pen.

Actually, the local retailers are more interested in the dollar value of this cattle. If each steer sells for an average of $30, then the value of the herd is $15,000.

30 dollars × 500 steers = 15,000 dollars

1 steer

Substituting the earlier expression for the 500 steers results in

30 dollars × 25 steers × 20 minutes = 15,000 dollars

1 steer 1 minute

or, taking the product of the first two terms,

750 dollars × 20 minutes = 15,000 dollars

1 minute

a flow or × time = a stock

rate

While cowboys and shopkeepers may not have consciously thought about a flow and a stock of dollars, we often do.

C. Saving versus Savings

Consider any household’s finances. It has an income which is used to purchase goods and services now or goods and services later. Economists would call the former consumption and the latter saving. Consider the schematic of a household’s finances on the next page. All three variables are flows. A household’s income conveys little information without being anchored to a period of time. For instance, suppose the Smith household has an income of $10,000. Are they rich or poor? One cannot tell without a reference to a period of time. If the Smiths’ income is $10,000 per year, they are poor. If their income is $10,000 per day, they are rich. Pretend that the Smiths have a modest annual income of $40,000. What will they do with it? If we assume for the moment that there is no government confiscating a portion of their income through

taxation, the Smiths will either spend their income or save it. Like income, both these actions will be flows. Suppose that the Smiths spend $35,000 of this year’s income on goods and services. The remaining $5,000 is saved; it constitutes their savings at year’s end. These savings exist at a point in time and are a stock. Consider the following diagram. Suppose

the Smiths had earned $40,000 per year for each of the previous four years and saved $5,000 in each of those years. With respect to the diagram, the 5,000 dollar saving flow runs into a pool of accumulated savings. At the end of five years there would be $25,000 in this pool or stock of savings. Recall that without a reference to a period in time, it could not be determined whether an income of $10,000 meant the Smiths were rich or poor. By itself, savings of $25,000 is not enough to determine the Smiths’ financial well being, but a period of time need not be attached to this sum for it to be fully understood. If the Smiths are a young household, $25,000 of savings would suggest that they are in good shape. If the Smiths are a retired couple, only $25,000 of savings would be ominous.

D. Deficits and Debt

The distinction between a flow and a stock is the key to understanding the relationship between the government’s deficit and debt. The following schematic illustrates the government’s financial activity. Taxes make up the government’s income which is then spent on whatever the government deems necessary.

Taxes and Government Spending are both flows; neither have much meaning without a reference to a period of time. Suppose the government collects $50 billion in taxes this year and spends all of it on goods and services. In this case the government is running a balanced budget.

Suppose the government collects $50 billion in taxes, but finds it necessary to spend $60 billion. It must then borrow the difference of $10 billion; this is the deficit budget for the current year. This is illustrated in the diagram on the following page. The financial markets are where borrowers and lenders negotiate. While household savings could reside in a cookie jar, most households would seek to lend their savings at interest (i.e., put them into the financial markets). Government bills, notes, and bonds represent interest paying alternatives to the cookie jar. To make up this year’s deficit, the government must sell $10 billion worth of these obligations. At year’s end, these obligations are still in the hands of the lenders and will stay there until the government repays the loans. These outstanding bills, notes, and bonds represent the government’s debt. This year’s deficit (a flow) added $10 billion to the government debt (a stock). If the government continued this activity over five years, i.e., borrowing $10 billion per year (or running a $10 billion deficit each year), the government will have accumulated a debt of $50 billion.

When tax collections exceed government spending a surplus budget exists. Suppose the government collects $60 billion in taxes, but spends only $50 billion. The difference of $10 billion is the surplus or excess of tax collections over spending. Had the government anticipated this surplus in advance, it might have merely reduced taxes accordingly to yield a balanced budget. Alternatively, the government may use the surplus to draw down a debt that has accumulated from earlier years. The figure below illustrates the surplus. Though unlikely, the

government could hold the surplus in its own cash balances which would be tantamount to the government’s cookie jar.

Of course, government is not the only entity that can go into debt. Households borrow to buy homes, automobiles, and appliances. Businesses borrow to meet short term needs such as financing inventories (e.g., workers typically do not want to wait for their product to be sold before they get paid) and long term needs such as new plants and equipment.

Chapter 2. Circular Flow

A. Real Flows

While the legendary King Midas valued money for its own sake, most do not. When “push comes to shove” people are eminently interested in what money will buy rather than the money itself. In terms of the current discussion, people are more interested in the flow of goods and services than in a flow of money. The figure below identifies this flow of goods and services that moves in the opposite direction from the consumption expenditures that were first identified in the figure on page 3. The top portion of the diagram shows how households get the money

to buy the goods and services. They sell their services to those same businesses. For example, Mr. Green sells his services as an assembler to Chevrolet and, subsequently, purchases a car that he helped assemble. The diagram suggests that households own everything and businesses own nothing. Some may protest this abstraction by arguing that businesses own plant and equipment. Indeed, Chevrolet (or General Motors) may own the assembly plant in St. Louis, but who owns General Motors? The stockholders. All of whom are members of one household or another.

If interest lies in the flow of goods and services, why bother with the flow of money (consumption) from the other direction? “Goods and Services” encompass a lot of stuff.

Chevys, Fords, Toyotas, Tommy Hilfiger tee shirts, American Eagle tee shirts, Nike running shoes, New Balance running shoes, Wonder bread, Oscar Meyer hotdogs, Krey Ballgame hotdogs, Campbell’s tomato soup, Dr. Barnard’s heart transplants, Macintosh computers, Faber Castell pencils, . . . thousands of products are part of the flow of goods and services. How can such a flow be condensed into a manageable measure? To illustrate, consider a simple two-good economy where only bread and beer are produced. Suppose the production/consumption for the year is 100 loaves of bread and 100 pints of beer. One cannot add the volume of each to arrive at any meaningful figure. In the following year, suppose that more bread is produced but less beer, say 120 loaves and 90 pints. In which year is the economy better off? Teetotalers would argue that the economy is better off with less beer in year 2. Under the more common criterion of “more is preferred to less,” a judgment cannot be made. The bottom line is that even in a simple two-good economy, measuring the inside flow of the circular flow diagram will make intertemporal comparisons difficult, if not impossible.

Which year is better?

The cattle drive of the previous chapter proffers an answer. Recall that the initial flow variable was 25 steers per minute which could be converted into a dollar flow by multiplying it by the price of a steer.

30 dollars × _25 steers = _750 dollars_

1 steer 1 minute 1 minute

Multiplying the volume of each good or service by its price will result in dollar flows that can be easily summed. Suppose the bread sells for a dollar a loaf and the beer sells for $1.50 per pint. In year 1, the level of consumption would be.

100 loaves × 1 dollar + 100 pints × 1.5 dollars = 250 dollars

1 year 1 loaf 1 year 1 pint 1 year

Assuming that the prices do not change in year 2, the level of consumption would be.

120 loaves × 1 dollar + 90 pints × 1.5 dollars = 255 dollars

1 year 1 loaf 1 year 1 pint 1 year

In terms of the diagram, the dollar flow in the two years would appear as follows.

Under the presumption that the market prices of $1 per loaf and $1.50 per pint reflect the relative value that consumers place on each of the products, it can be reasonably asserted that there is an improvement in economic well being in the second year. The income/consumption flow has grown, in this case by 2 percent.