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# The circular flow - a more detailed version

We need a more detailed version of the circular flow model in order to understand important issues in macroeconomics. However, even the more detailed version must be a simplified model of the real world. We will only include details that are important for the understanding of macroeconomics at this level. All the details and the exact definitions would use up too much space.

To make the figure less complicated, we start with the firms. Then we draw the circular flow using two parts. In the first part we illustrate how goods flow between various sectors of the economy, while in the second part we show how money flows.

# Modeling a firm and the concept value added

Before we look at the more detailed version of the circular flow, we will illustrate the model of the firm that we will use in this book.

Fig. 4.2: Firms in the circular flow.

A firm in our model is a unit which adds value to products. These products may be raw material, semimanufactured goods, final goods and services. By adding value, we mean that the firm acquires the good, adds value to it and then sells it. A supermarket adds value to a final good by making it more available to consumers and a bakery adds value to flour when it bakes bread.

Firms add value by using factors of production (mostly various forms of labor and capital). We define value added as the difference between the revenue and the cost of the goods. If a supermarket buys a fish for 4 euro and sells it for 5 euro, it has added 1 euro of value to the fish.

From the diagram we see that the value added in a firm must be equal to the compensation to the factors of production. This must be the case since the net flow of money for a firm must be zero (remember that profits become return to capital - a compensation to the owners of the firm).

# Firms in the circular flow

We divide all firms into three categories: FR consists of all firms that acquire raw material (iron ore, farm products and so on), FH all those that produce semi-manufactured goods (steel, pulp and so on) and FF all firms producing finished goods (software, cars and so on). We use the symbol Y for GDP. All of Y will go to the firms in the FF box. However, if we sum the value added from all firms, we will get exactly Y. This is why:

Fig. 4.3: Goods in the circular flow.

• If YR is the total value of all goods going from FR to FH, then the total value added from all firms in the FR box is equal to YR (they do not purchase any goods to which they add value).

• In the same way, if the total value of all goods going from FH to FF is given by YH, then the total value added from all firms in the FH box is YH - YR.

• In the same way, the total value added for all firms in the FF box will be equal to Y - YH. If we sum all the value added from all firms, we get YR + (YH - YR) + (Y - YH) = Y.

• This result is independent of how many "levels" or boxes we have in the production process. Instead of three levels, we could have any number of levels and the result would still hold. Also, a particular firm may be producing in several of the boxes.

Since the value added in each firm is equal to the return to the factors of production, the total return to the factor market must be equal to the sum of value added from all firms, which is equal to Y.

# Circular flow - circulation of goods

Figure 4.4 shows a more developed version of the circular flow. In this figure we see how goods flow through the various sectors of the economy.

Fig. 4.4: Money in the circular flow.

• In addition to the private sector we now include the Government and the Rest of the World in this model.

• Finished goods in the goods market are divided into four categories: private consumption going to the private sector, public consumption for the government (health care, education, defense and so on), investment going to firms and export to the rest of the world. To this flow we must now add imports from the rest of the world.

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