1. Chapter 3 The American Economy in a Global Setting

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-2 “What Goes Around Comes Around” When firms prosper, so do households. When households struggle, so do firms. What are the economic forces that connect the well-being of households and firms?

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-3 Chapter Objectives After studying chapter 3, you will know:  How households and firms are connected by a circular flow of economic activity  How the product and resource markets connect households and firms  What role the government plays in the economy

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-4 Chapter Objectives (cont’d)  What role financial markets play in the economy  How imports and exports affect the circular flow of economic activity

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-5 The Circular Flow of Economic Activity Households and firms interact so closely that the well-being of one depends on the well-being of the other. This interaction is represented by the circular flow model.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-6 Figure 3.1 The Circular Flow of Economic Activity

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-7 Households and Firms: The Product Market Households purchase goods and services from firms in product markets.  Spending flows from households to firms.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-8 Households Characteristics:  One-fourth are headed by single individuals.  About half are headed by two parents.  They are aging.  They are geographically mobile.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-9 Firms Firms take on many different forms:  Sole Proprietorships Only one owner  Partnerships Several owners pool their resources.  Corporations Sell ownership in the form of stock

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-10 Figure 3.2 The Changing Pattern in U.S. Production Between 1947 and 2004

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-11 Changes in the U.S. Economy Major trends:  The emergence of the service sector Between 1947 and 2003 there has been explosive growth in:  Legal services  Health services  Social services  Firm to firm transactions Represent 14% of purchases in product markets

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-12 Households and Firms: The Resource Market Firms hire factors of production from households in resource markets.  Income flows from firms to households.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-13 Exchange in the Resource Market Income takes the form of payments to:  Labor, which earns wages, salaries, and other compensation  Landowners, who earn rent  Capital, which earns interest  Entrepreneurial skill, which earns profit Proprietor's income and corporate profits

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-14 Figure 3.3 Sources of Income in the United States Economy in 2004

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-15 Using the Circular Flow The circular flow model provides important insight into the economy and public policy.  Households and firms—and their economic health—are linked together by flows of spending and income.

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-16 The Government Sector of the Economy The government also affects the circular flow of economic activity.  Direct effects: Adding to or taking from the flow of income  Indirect effects: Purchasing goods and resources in markets

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-17 Levels of Government and the Circular Flow Local Government  Collects property taxes  Provides parks, museums, schools, police protection State Government  Collects sales taxes  Provides roads and school systems Federal Government  Collects income taxes  Pays transfer payments  Provides national defense and interstate highways

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-18 Government Spending, Government Revenue, and the Circular Flow Government adds to incomes by providing transfer payments.  A shift of funds from one group to another  Do not involve exchange or transactions  An injection into the circular flow

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-19 Government Spending, Government Revenue, and the Circular Flow (cont’d) The government takes away from the flow of income through taxes.  A leakage from the circular flow

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-20 Government Spending, Government Revenue, and the Circular Flow (cont’d) Government spending refers to the government’s transactions in product and resource markets.

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-21 Spending, Taxes, and the Budget Deficit A federal budget deficit occurs when the government spends more money than it takes in.  Financed by selling securities Conversely, a federal budget surplus occurs when tax revenues exceed government spending.

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-22 The Financial Sector Households also save some of their income.  A leakage from the circular flow Firms require funds to buy capital. The financial sector brings savers and borrowers together to recycle funds into the economy.

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-23 The International Sector of the Economy Up to this point, we have looked at a closed economy.  Based on the assumption that households and firms don’t engage in international trade An open economy is an economy that does engage in international trade.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-24 Trade and the Circular Flow Imports are goods that are purchased from foreign producers.  A leakage from the circular flow. Exports are goods that are produced domestically and sold to foreign buyers.  An injection into the circular flow.

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-25 Trade and the Circular Flow (cont’d) The difference between exports and imports is called net exports.  Trade Surplus  Trade Deficit

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-26 Table 3.1 U.S. Exports and Imports in 2004 by Product Group (in Billions of Dollars)

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-27 Life Lessons No economy is an island.  The well-being of nations is closely linked through the international sector of each nation's economy.

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-28 Strategy and Policy Unexpected Victims of Taxation  Who could complain about taxing the yacht industry, an industry that caters to the rich and powerful?  Many unskilled workers lost their jobs!

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-29 Summary The Circular Flow of Economic Activity  Income cycles from households to firms and back again. Households and Firms: The Product Market  Households exchange money for goods and services from firms. Households and Firms: The Resource Market  Firms pay income to households in exchange for factors of production.

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-30 Summary (cont’d) The Government Sector of the Economy  Governments enter the flow through taxes and spending. The Financial Sector of the Economy  The financial sector connects savers and borrowers. The International Sector of the Economy  Imports are a leakage while exports are an injection.