Models
This is the first in a series of notes for a semester-long macroeconomics course. The point of the course is to create a practical and open-ended introduction to macro, with a coherent role for money and without reproducing IS–LM.
In macroeconomics, as in economics more generally, one frequently talks about a conceptual “model” of an economic system. But what do we mean by this word model? To start, you can picture a model airplane, or a model of the Solar System. This kind of model shows the largest components of the thing being modeled, and represents the relationships between those parts. However, the model is smaller, simpler and less complete than the original. An economic model is this kind of thing. It tries to illustrate the most important parts of an economic system in a context that is smaller and easier to understand than the real thing.
Our two-sector division of the macroeconomy is a first model of the system of production, labor and exchange. Below is one way we can write out this two-sector model. In this style of writing out macroeconomic relationships, each sector gets a two-column T account. At the moment, we are working with two sectors, a household sector and a business sector, but later we will have more. The two columns of each sector are labeled “uses” and “sources.” We will always write uses on the left, and sources on the right. That’s just a convention—the only reason to do it that way is so that we can all understand each other.
Sources and uses are short for sources of funds and uses of funds. What does this mean? We think of each sector as receiving payments, which are its sources of funds, and making payments, which are its uses of funds. The household sector, for example, receives payments in the form of incomes from business. That includes the regular wages and salaries that workers receive as compensation for their labor. It also includes profits paid to the owners of businesses, as well as interest and dividends on savings and investments. In other words, we are grouping together all household incomes. This is a source of funds to the household sector, and we write it in the right-hand column, labeled “sources,” for that sector. These same income payments are a use of funds for the business sector, so we write it in the left-hand column, labeled “uses,” for that sector:
Households also make payments. In this simple model, the only thing households can do with their funds is to buy the product of businesses. We write that on the left-hand side for Households, under uses of funds. Those same payments become a source of funds for the business sector.
In a macroeconomic model, we imagine payments coming in and payments going out for each sector. We do not allow payments to appear from nowhere, nor do we allow them to disappear. Every payment coming in to a sector has to go somewhere, and every payment going out has to come from somewhere. We formalize this with two important rules. First, for each sector, total sources of funds must equal total uses of funds. If for some sector total sources and total uses are not equal, that means we have missed something and our model is incomplete. In the two-sector model we are looking at right now, household sources of funds and household uses of funds are both $27 trillion. Business sources and uses also total $27 trillion. So the first rule is satisfied.
Second, each entry represents funds flowing from a sector to another sector. Funds are not allowed to appear or disappear between sectors. So, each entry appears once as a source of funds and once as a use of funds, in equal amounts. Above, we show incomes as a source of funds for households and a use of funds, in the same amount, for businesses. We show sales of product as a source of funds for businesses, and a use of funds for households. So the second rule is also satisfied.
To be clear, the two rules are:
total uses equal total sources for each sector, and
each entry appears as a use and a source, in equal amounts.
In order to make progress in macroeconomics, we will need to be able to think clearly about sectoral relationships. This way of writing them down, with T accounts and sources and uses accounting, is a good way to do it, because by following the two rules you will avoid some mistakes that would otherwise be easy to make.
Finally, we should ask whether this model is a good one. It is pretty simple, reducing a year’s worth of production to two two-sector entries. It is meaningful, because the household-businesss sector does give rise to reasonable definition of GDP and this is the most common measure of total economic activity in an area during a period of time. At the same time, it seems to have some obvious omissions—there is only one country for example, and only one kind of business, no government, and so on. We will quickly need to move on to more elaborate versions.