This is the second in a series of notes for a semester-long macroeconomics course. The first note is here. 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.
Let’s look again at the production sector. Up until now we have used a two-sector economic model, in which all production takes place in a single “business” sector. We can make this a little more elaborate, which will let us speak to some important macroeconomic questions. We’ll do this using a macroeconomic model in which production takes place across three sectors, the final output of which is sold to a single household sector. Production across the sectors is linked in a very particular way, which we can describe as a supply chain.
The supply chain model is written out using sectoral T accounts below. Households are on the left. The business sectors are arranged from right to left. The first business sector we refer to as extractors—a representative example would be a business that mines copper from the earth, or a farm that produces ethanol from corn. We think of the output of the extractive sector as providing inputs to manufacturers, who combine these resources into finished goods. Finally, retailers sell these finished goods to households:
The arrangement of T accounts follows the examples we have seen before. Households earn incomes, their sources of funds, and spend these incomes buying product from the retail sector. What is different is that this model incorporates intermediate product, the sales of product from one business sector to another, on their way to eventual final sale. Manufacturers, for example, take in the product of the extractive sector, a use of funds for manufacturers and a source of funds for extractors. They then sell their products to retailers, a use of funds for retailers and a source of funds for manufacturers.
It will be helpful to see the relationship between this supply-chain macroeconomic model and the two-sector model of production that we have seen before. We can see the connection in two steps. First, write the transactions for the three business sectors (extraction, manufacturing and retail) on a new T account for a single business sector. This is called aggregation, and it means that we take what had been multiple different sectors and group them to think of them as a single sector. The resulting model looks like this:
This creates an interesting complication, which is new to us with this example. After aggregation, our business sector shows several transactions with itself. In a way, the rules of accounting are still satisfied, since every source has a use, and total sources equal total uses for each sector. But now we have the aggregated business sector transacting with itself—the product of extractors and the product of manufacturers stay within the business sector. We can remove them in a step called consolidation, removing transactions that stay within a sector:
In other words, by aggregating and consolidating the supply-chain model, we come back to the original two-sector macroeconomic model.