Conceptual Tool #4: The Circular Flow Model
One goal of this series of posts is to understand distribution as not simply a matter of income or wealth (accumulated income), but by examining distribution across the system as a whole: how different parts of the economy fit together and how resources, goods and money move through it. The closest serious academic papers get to this type of holistic analysis is to use "general equilibrium"-type models, which just means that they attempt to model a labor market and a product market at the same time and see how they interact. I want to rewind a bit, back to macroeconomics 101, and take a somewhat a different route into the analysis of distribution.
Your average Introduction to Macroeconomics textbook is likely to feature the circular flow model of the macroeconomy. Sometimes it may feature more complicated flows (scroll down to the 2nd chart) as well. Circular flow models barely qualify as "models" in the standard economic sense, but I have written several pages about them here because they provide a valuable perspective.
Circular flow-style models are helpful because they provide us with a simple foundation for our understanding of the whole system of the economy, which serves as the groundwork for future intuition.
Also, the bird's-eye view they provide reminds us that the economy is a system with individual parts that play specific roles. By extension we can see that the way these parts could, in theory, be rearranged. For example, if production was done entirely by robots and then distributed to people according to something unrelated to the consumer's productive power, we could have an economy where producers and consumers were entirely distinct.
Circular flow models also help us conceptualize the two-way nature of economic transactions, where money flows in one direction and goods, services, or "utility" flows in the other.
Likewise, circular flow models do a good job of capturing the dual nature of workers/consumers: any flow from a consumer has to come from a paycheck, a fact which is both obvious and confusing, and has important ramifications that may be missed by standard models.
Finally, the looping nature of the circular flow model helps remind us that money (as well as everything going in the other direction) is flow that has to keep moving and does not stay put--we can see that if people or businesses or governments stop spending, even in one link of the chain, the flow dries up.
Unfortunately, circular flow models have several important weaknesses--primarily because the economy is difficult to capture in its entirety. Determining causality in the model--always a difficult task--is complicated both by the two-way nature of the flows, and by the circular nature of the model. Essentially, you end up with not only a chicken-egg problem because of the circular flow, but also a chicken-grain problem because of the two-sided markets: you cannot tell whether the chicken wanted to eat the grain or the grain wanted to be consumed by the chicken.
Moreover, trying to incorporate more complex connections between markets, for example including governments and financial institutions, presents too many unknowns to put meaningfully into equations (equations being a prerequisite for any pretensions toward "science"). The advantage of circular flow models, being able to see some of the economy's true complexity, makes them difficult to use for analysis quantitative analysis.
But circular flow models are also far from being complex enough. By assuming a single, "representative" household and business (and government), circular flow models ignore distribution within households or businesses. They also gloss over the different methods of transfers, e.g. wages versus capital gains versus debt interest. Finally, they present money and goods flows as steady and given, ignoring the fact they are caused by supply and demand incentives. (this is the causality problem again)
Despite these flaws, I still find myself attempting to conceive of a circular flow model useful for analysis, i.e. one that we could plug numbers into in a meaningful fashion, get some kind of predictive power from, or at least use to view the economy in a new light. Large think tanks, government agencies, and financial companies have attempted to create comprehensive models of the economy, probably these are useful for spitting out numbers, but they have not to my knowledge led to any obvious revelations in our understanding of economics.
What could a more useful version of the circular flow model look like? I will throw out some ideas.
- Maybe you have seen the animated visualization of wind developed by some clever researchers. What if we could do this with flows of money? If not using granular location data, then between states or internationally. Or, instead of using spatial locations, animate a traditional circular flow diagram in a similar fashion, showing flow strength between different sectors of the economy. Representative boxes (consumer, producers) could also change over time to depict things such as savings, indebtedness, inequality, or relative size in the economy.
- The author/entrepreneur Martin Ford tries to develop a visual metaphor for distribution in his book The Lights in the Tunnel, which examines the impact of technology on distribution (free e-book at the link). Ford describes a visual metaphor for individual incomes, a tunnel made of millions of lights, and describes how most get dimmer over time while a few get brighter. Basically he is describing a possible visualization of the gini coefficient (the most common measure of income inequality), but his emphasis on the change over time and the process through which those changes occur makes the metaphor interesting. If a more structural view of the economy, including product markets and other actors, were somehow incorporated into this metaphor it could get interesting.
- There are plenty of existing economic models featuring winners and losers from technology or trade. These models may explain changes in income between high- and low-skill workers, or between workers and capital owners. Unfortunately, lumping everyone into two groups is not always particularly revealing. Also, the models do a poor job of explaining anything more than a simple before-after scenario for an economic shock: they do not show stocks and flows of money and they can comprehend only rudimentary structural changes. They furthermore exclude entire parts of the economy like government and savings, and typically make strong, unrealistic assumptions such as full employment. These models are good at explaining individual phenomena, but have a difficult time providing a realistic, systemic understanding of an economy.
- There are certainly some interesting bubble charts to be made (and they many exist already) of sectoral distribution in our economy over time, or transfers to and from different between businesses, government, and different income groups. Two axes are limiting, however, even with the added
- It would also be fascinating to be able to visualize where and how economic rents accrue in an economy--at what stages, in what individual industries, and to what type of individuals and businesses.
Let's take a step back and recall what we are fussing about. We are looking for better ways of understanding the connection between production and distribution, and thinking about what we can learn from one type of basic representation an economy: the circular flow diagram. The circular flow diagram teaches us that money is a flow, it flows in the opposite direction of good and services, and it connects markets and so markets influence each other (e.g. we cannot have strong demand without decent wages).
What would some ideal model look like? It would show money and goods flows, not just direction but also the amount over time, and would be easy to disaggregate between not only the consumer and producer "sides" of the economy but also between industries, occupations, and different income groups. It would capture a range of "leakages and injections", as they are called, including international trade and financial flows, savings, inflation, and interest payments. It would also show stocks of wealth at various points.
One possible way to organize such a model would be with the life cycle of money, following it from its creation (loans in banks) through its use and final destruction (loan payments to banks). The difficulty with this method would be that money is fungible and there is no sensible way to determine money's "age" or where it came from or went to. A similar organizing possibility would be the life cycle of goods, but this gets difficult with things such as intellectual property, services, and more abstract types of value that do not have a clear product cycle.
I do not have such a model here to present to you. Merely the idea that with some hard work, lots of data, and some nifty graphics there is a lot of potential for representing our economy in revealing ways. It is important, I think, to keep as holistic a view of the economy as possible. The circular flow model is a nice format for presentation, but the complexity of flow in an economy, from money spent to money earned, is difficult to capture.