Cycles of Production and Consumption

The Traditional Economic Cycle of Production and Consumption

The first way of describing cycles of production and consumption can be found in traditional macroeconomic descriptions of society and is often referred to as the “circular flow of income” (see, e.g., Mankiw and Taylor 2006). In its most simple form, society can be described as a two-sector model of firms (producers) and households (consumers). Figure 1 provides a visual representation of this approach. Firms produce goods and services that are delivered and paid for by households, causing a monetary flow that is a reverse of the physical flow. In turn, households provide labor and capital (so-called factors of production) to firms, for which they are paid in the form of wages, rent, and dividends. The monetary flows have to be in balance and the value of the factors of production used per unit of time in principle has to meet the value of the products and services produced per unit of time.

Somewhat more sophisticated representations include three other main sectors: the finance sector, the government sector, and a “rest of world” sector. The finance sector borrows savings (from households) and lends it to parties investing capital (firms). This money hence “leaks” from the primary cycle, since it is not used anymore to purchase consumer products and services. Yet, the finance sector again puts this money back in the loop in the form of loans, which then are used for the purchase of other (capital) goods and services. The government sector levies taxes on households and firms and hence creates another leakage, but at the same time shuttles this money back in the form of government expenditure (wages for government workers, payment for public services and public infrastructure). Finally, a rest-of-world sector can be introduced (i.e., other countries from which goods and services are imported and to which domestically produced goods and services are exported). The imports need to be paid for and form a leakage in the monetary flow, whereas exports form a leakage in the physical flow of products and services (but add to the monetary flow). Figure 1 also gives a stylized representation of the five-sector model. The five-sector model is in (monetary) equilibrium when savings (S) plus taxes (T) plus imports (M) equals investment (I) plus government spending (G) and exports (X), or, in formula: S + T + M = I + G + X.

...