Author: John Bouman

  The Simple Circular Flow Model In its simplest form, an economy consists of buyers and sellers. Sellers are businesses that obtain resources, including land, labor, capital goods, and raw materials and use these to produce and sell goods and services. Households provide (sell) their labor to businesses, and use the income to buy products. Households also may own land, capital (money), capital goods, and raw materials which can be used for production. In the graph below, a simple circular flow diagram shows the economic interactions between households and businesses. This paints a simplified picture of how our economy works. The Circular Flow with Government and Foreign Markets A more realistic picture of our economy also incorporates the economic interactions of two other main participants in our economy: a government and foreign markets. This is illustrated in the diagram below. Governments provide services to businesses, households, and foreign markets, and collect taxes to pay for these. Foreign markets buy and sell goods and services to and from our households, businesses, and governments. So a typical economy consists of four main groups: households, businesses, governments, and foreign markets. The circular flow model illustrates the interactions between these four groups. Video Explanation For a video explanation of the circular flow, please watch the following:...

The Three Economic Systems 1. A laissez-faire economy. Laissez-faire is French for “let do.” It means “hands-off” and represents a pure capitalist system, or a so-called price system, in which the supply and demand behavior of businesses and households determine prices of goods and services and factors of production. The government plays an important role in a pure capitalist economy, but its role is limited to only the most essential functions such as providing a legal system, protecting individuals and private property, providing infrastructure and providing certain public goods. 2. A command economy. A command economy is a communist system in which a country’s government determines prices of goods and services and factors of production. The government is in control of all of the country’s economic decisions. 3. A mixed economy. A mixed economy is a combination of the two systems. Most industrialized countries around the world have mixed economies. The exact mix differs depending on the amount of government involvement. Economic Systems around the World The United States, Canada, Mexico, South Africa, China, Sweden, England, Norway, Japan, South Korea, Holland, Germany, and most other industrialized countries are examples of mixed economies. The private sector (businesses and households) plays a significant role, but so does the government in the form of various types of government spending, taxation, regulations, price controls, and monetary policies. During a significant part of the...

In this section we clarify several concepts that we will come across throughout our text. Nominal and Real Values Nominal values, such as nominal prices, nominal earnings, nominal wages, nominal interest rates, and nominal Gross Domestic Product, refer to the actual dollar value of these variables. A person who earns $10 per hour in today’s dollars earns a nominal wage of $10. Real values are values in comparison, or relative, to price changes over time. You may earn $10 this year and you may earn $10 five years from now. Your nominal income remains the same, but $10 five years from now is not worth as much as $10 now. The real value of $10 five years from now is less than $10 in today’s dollars. We also distinguish between real and nominal when we discuss interest rates. Real interest rates are nominal rates adjusted for inflation. In other words: real interest rates = nominal interest rates – inflation. For example, if you pay your bank 6% in nominal interest, you are only paying 2% in real interest if prices are rising by 4%. Positive and Normative Economic Statements Positive economic statements are facts, or statements, which can be proven. Normative economic statements cannot be proven. They are opinions or value judgments. A positive statement does not have to be a true statement. The statement could be proven false,...

Question Everything Critical thinking is particularly important in today’s Internet society and world of information overload and fake news. Authors, journalists, economists, politicians, talk-show hosts and even Hollywood celebrities and famous athletes make controversial and sometimes contradictory statements and express their opinions about social, political, and economic issues. It is useful to read their statements and to listen to their opinions, but we must question everything. If we don’t, we could end up with laws, regulations, and economic policies that harm our economy and our country. Critical Thinking Guidelines When evaluating a statement we must: 1. Question the source. Study the background of the person making the statement. If a union leader provides arguments and statistics to support her/his claim that trade restrictions are beneficial to the American economy and that free trade leads to increased unemployment, we need to consider the source. The union leader’s objective is to represent her/his constituency (union workers). Therefore, (s)he is biased and will make arguments to support her/his union agenda. This doesn’t necessarily mean that the union leader is incorrect. However, when a person is biased, we must be prepared to question the validity of the arguments. We should, of course, evaluate and analyze all statements, but in particular from people who have an apparent bias. 2. Question the assumptions. An assumption is information you presume to be true. When several decades...

What’s in This Chapter? Why do prices of houses, cars, gasoline, and food fluctuate? What explains increases and decreases in interest rates? Why do prices of stocks and bonds change every second? Why does one gas station charge more than an other? Why are salaries of restaurant servers and kindergarten teachers lower than those of social media celebrities, well known athletes, and doctors? Why is it less expensive to visit other countries after their foreign exchange rates decrease in value? In a free market economy, the answer to all of these questions is: “It is because of changes in supply and demand.” When the demand for a product increases, then its equilibrium price increases, and vice versa. When the supply increases, then the price decreases, and vice versa. The mechanism of changing prices in a free market economy is powerful. When buyers want more of a product, and can afford it, they communicate this by buying more of the product. This increases the product’s price. The higher price gives producers an incentive (and the financial ability) to make more of the product. The resulting greater supply satisfies the greater need. The increase in supply also brings the price back down in the long run (assuming the cost of production doesn’t change). Overall satisfaction and the nation’s standard of living increase because buyers and sellers communicate to each other and...