How the Economy Works - A Visual Tutorial

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Spending, Saving, and Recessions

The economy is an incredible machine that can improve our lives. This visual tour of how it works will take you beyond the myths!

As we can see with our own eyes, the sun orbits the earth, right?

Our intuitions about the world can mislead us -- of course we now know the earth orbits the sun! The economy can be confusing too, but step back far enough and your perspective may change. This tutorial won't launch you into space, but it will explain the economy with visual metaphors that provide a comparable sense of perspective.

The economy is the sum of everyone's work (labor). We seek prosperity, striving to satisfy our needs and our wants while constrained by our available time, skills, and resources. We'll look inside this black box that historically has powered an enormous increase in the standard of living for so many people. With the right fine tuning, the economic machine can lift many more people out of unemployment and poverty than it has to date -- without merely redistributing from the haves to the have-nots.

These insights draw upon a revolution in macroeconomics that has been quietly unfolding in academic circles outside the mainstream for several decades. You'll learn how deficits and debts of most national governments differ from household borrowing, why money is unlike gold and other commodities, and much more!

Check your politics at the door but pick them up when you leave -- a true understanding of the economy leaves open the political choice for large or small government.

Here is a core part of the metaphor. The money we spend is like a flowing river cascading over a water wheel to power the economy's production of goods and services. The flow forms a circular loop where spending becomes income which becomes more spending... While some of the water leaks away through outbound channels, elsewhere inbound streams add to the main flow. Starting on the next page, we'll begin to examine the implications.

Please maximize your browser and click the NEXT button at the top of the page to continue. (On Windows, the F11 key toggles full screen.)

In the economy as a whole within any given time period, total spending equals total income. (Think about how each dollar you spend on goods and services is a dollar earned by other people.)

How to Read Additional Details

The sidebar adds extra details about each page's theme, including graphs of real world data and links to more information.

A [?] at the end of a yellow text box in the diagram indicates supplemental information is available by clicking.

See Real World Data

The water's circular flow begins as one person spends money on goods and/or services. A farmer might ask to buy bread from a baker.

Water (spending) turns the water wheel by paying for the production of what was purchased. The baker fills the order by grinding flour and baking bread. (If the bread was pre-made, the new baking instead replenishes inventory.) [?]

The choice of production in this example (bread) fits historically with the chosen water wheel metaphor, however the water wheel represents ANY production of goods or services in the economy.

The examples are as numerous as there are professions: anything from farming to computer manufacturing to babysitting to musical performance!

The buyer benefits from the output that was produced. The farmer eats bread sold by the baker.

The payment represents new income for the seller. The baker gets paid by the farmer.

The income is deposited into a bank account and is available for new spending. The cycle can repeat -- the seller (baker) might now buy from other people (farmer). [?]

In this example, the baker might spend his new earnings, perhaps to buy wheat from the farmer as an ingredient for future bread production.

When we add up all these transactions happening across the economy during one year, the total production is called GDP (Gross Domestic Product). It is equal to our national income. [?]

An equivalent measure is called GDI (Gross Domestic Income). It is conceptually the same as GDP but is measured differently.

(GDI is estimated by adding up all domestic incomes, while GDP is estimated by adding up all purchases of domestically produced goods and services.)

Read more in the sidebar and by clicking on [?] boxes.

What if we save instead of spend? Savings are an important component of our total wealth, but they don't participate in the circular flow of income!

Additional Concepts

Stocks and flows: Economists refer to savings as a stock and spending as a flow and it is important to distinguish between them. Stocks are quantities of something (think of the reservoir, e.g., measured in gallons), and flows measure a quantity per time period (think of movement of water through a river, e.g., measured in gallons per minute).

Financial versus net financial assets: Financial assets include bank deposits, corporate bonds, treasury bonds, etc. Net financial assets measures financial assets remaining once you subtract liabilities (i.e., debt). This is essentially net worth excluding tangible assets. See a graphical balance sheet representation of net financial assets

See Real World Data

Income that is saved (i.e., not spent) enters a reservoir outside the circular flow loop. Savings don't automatically become a flow of new business spending! (More on this soon). Saving is a LEAKAGE to the circular flow. [?]

The simplified economy pictured here has $12 of savings: $4 held by the wheat farmer, $4 held by the bread baker, and $4 held by all other individuals and businesses combined.

Financial savings can be held in different types of accounts: cash and checking accounts are often used to hold money that will be spent soon, while savings and investment accounts often hold longer term savings.

One school of economic thought claims that all savings will automatically re-enter the flow loop as new investment (with possible help from an adjustment in interest rates), but this is incorrect. Some of "invested" savings are likely to generate new economic activity in the circular flow (perhaps after a time delay!), but in the real world there is no automatic relationship. More on this topic later.

Tangible assets (homes, computers, etc) are part of our economic output and total wealth, but aren't used directly for spending. People don't spend houses, they spend dollars (perhaps after selling houses to acquire dollars). [?]

Tangible assets (as opposed to financial assets) are not shown in the later pages of this visualizer, despite being an essential part of the economy.

Think of money as the life-blood of the economy, facilitating all transactions other than barter or volunteerism. Transactions frequently involve the production or exchange of tangible assets. But money is how we receive our income and measure the flows of exchange. It facilitates production and consumption, analagously to circulating blood enabling the body to function.

So, financial assets and financial flows receive primary emphasis in this visualizer because they are key to understanding the economy's behavior.

Money flows matter because they are the life-blood of the economy, facilitating the majority of transactions as well as signaling which tangible assets need producing. Money "stocks" (reservoirs) matter because most people want to grow their financial savings (bank accounts, CDs, bonds, etc).

Think of each $ symbol as data in a computer. The vast majority of the money supply is electronic accounting entries at banks, not physical cash (notes and coins). So, in the real world, most of the circular flow shown here is actually near-instant electronic transactions. [?]

[COMING SOON: Statistics on composition of money supply between physical currency and electronic bank deposits, along with graphs and external links.]

One of the most critical misconceptions to overcome is the false notion that money is a commodity! All money is debt (a liability of government or banks), and its quantity and type both dynamically adjust to the actions of households and businesses. Even under a gold standard, money was not a commodity. More details on this later!

If we cumulatively begin to save more per time period, then total spending and thus incomes fall. What is virtuous for individuals becomes harmful for the nation, and absent other factors, the result is recession and increased unemployment!

Visual Illustration

Click to have households on average decide to save 20% of their current income, that is, one out of every five dollars of income. The $ to be saved is marked in orange. In this example, after the first year, households lower their savings rate back down to 0%.

An Example Scenario: Consider again the miniature economy represented by the farmer and baker. Imagine that the farmer decides to start saving for retirement and stops buying bread from the baker. As a result, the baker's income drops and he can no longer afford to buy wheat from farmer! Thus the farmer's income falls too, thwarting his attempt to save for retirement. Economists refer to this as the "paradox of thrift."

See Real World Data

Consider a sample economy circulating $5 of spending and income each time period.

Next, consider what would happen if some people decided to spend less than before in order to build their financial savings or pay down debt.

Absent other changes (to be considered on later pages), the result is that GDP (i.e., national income) will fall! This growth gauge would go from flat (0%) to negative growth.

If growth is negative enough for long enough, we say the economy is in a recession. Because national income drops, some employed workers lose their jobs and are unable to find new ones!

Does business investment grow to offset falls in consumer spending? No, investment spending usually shrinks during recessions too! (And most surprisingly of all, even during expansions, investment does not rely on prior savings!)

Additional Information

Business investment is cyclical: While there will be individual exceptions, averaged across the entire economy (and especially once you include the largest producers) businesses overall will not expand investment until they can project when that capacity will be needed. As such, business investment is called cyclical, that is, it amplifies whatever trend is in place, expanding during economic growth and contracting during recessions.

Interest rates: Risk-free interest rates are determined by government policy (primarily by the central bank). This control is direct for short term interest rates, and indirect (via market expectations of future short term rates) for longer term rates (more details later). Private sector interest rates are based on the risk-free rate plus an appropriate risk premium (to cover the possibility of borrowers defaulting). Interest rates do NOT fall simply because households and companies are adding to their financial savings -- the quantity of money concept of interest rates is incorrect for countries with floating currencies like the US. And even if the central bank chooses to lower interest rates, the effect on investment is limited.

See Real World Data

Business investment involves companies spending money to upgrade their capacity, e.g., building factories, buying software, training workers, etc. The added water flow (representing the new investment activity) results in upgrades to the water wheel's capacity to produce output.

Why would businesses with sufficient existing capacity expand investment when GDP is falling? While there will be individual exceptions, totaled across the entire economy, they won't! Thus, the baker won't borrow money for building a second mill unless he expects growing sales to need that capacity in the forseeable future. [?]

Business investment is considered pro-cyclical. (LINKS).

Even if the central bank lowers interest rates, nothing automatically causes all savings to become new business investment! Remember, in economics there are stocks (quantities) as well as flows! Thus, in any given time period, a "stock" of savings sits idly in bank accounts, without the bank somehow "putting the $s to work" behind the scenes. [?]

Some branches of macroeconomics include the idea that prices and interest rates will always adjust to "clear", allowing the system to reach "equilibrium". This is a theory carried over from 19th century physics that doesn't apply in the real world of economic systems. COMING SOON: More details & external links.

Investment is an ambiguous word -- most "investment" just uses markets to swap who holds existing assets -- bonds, houses, bank deposits, etc. It does not fund new income-producing economic activity unless it buys newly issued corporate bonds or shares that enable new business spending.

At no time (during recessions or expansions) is business investment constrained by existing quantities of savings. Bank loans create funds "out of thin air", so no one has to save first! Yes, unbelievable as it sounds -- banks do not lend out your money! More detail later. [?]

Business investment can be funded in any of these ways:

Retained earnings (the firm's own savings)
Direct borrowing from other savers (for example issuing corporate bonds to investors)
Bank loans

Banks can issue loans without anyone saving first! Banks do not even need to attract deposits first — loans create deposits!

Thus, business investment is not dependent on savings. In the circular flow graphic, new $s can appear in the reservoir "out of thin air" (but with matching debt liabilities) and enter the circular flow. (VISUALIZATION TO BE ADDED).

Visit the Macroeconomic Balance Sheet Visualizer and choose 'Bank Loan' from the operations list to see this graphically.

More on bank lending and its constraints

We've covered the basics on spending, saving, recessions, and business investment and how to visualize them using the water flow metaphor. Let's lay some more groundwork before stepping back to see the illuminating view of how the pieces fit together.

Summary so Far

Total spending equals total income in any one time period.
All money is debt (liabilities of banks or government), not a commodity. Most of it is electronic accounting entries, with a small percentage reserved for withdrawal as physical cash.
Saving is a leakage from the circular flow of income, and the reservoir of accumulated financial savings can be idle (that is, not contributing to national income) during any given time period.
If we cumulatively begin to save more, than absent other factors, national income will drop, likely causing recession and increased unemployment.
Business investment is a core part of the economy, but it tends to fall rather than rise during recessions.
Financial investment is not the same as business investment. Buying existing stocks, bonds, houses, etc simply trades who holds which existing assets. (Markets manage the relative prices of these assets.) Nothing forces savings to become new income-producing business investment.
Because bank loans create money "out of thin air", investment does not even rely on past savings. (Note that new money from bank loans has a matching liability so no one gets "free" money.)

This is the end of Part 1. Click "Next >" again to continue immediately to Parts 2 and 3. Or you may return to them later via the home page tutorial menu. *

Work In Progress

* Please offer feedback if you think there is a better way to handle dividing up this content.

National Government

A national government that controls its own currency can essentially spend at any time by crediting bank accounts and tax by debiting them. (With no need for wheelbarrows of cash or nightmares of inevitable hyperinflation!)

Visual Illustration

Click to see the how the government's role as the monopoly issuer of the currency allows it to spend and tax independently. It never has to "save up" in order to spend!

Each $ of spending appears out of nothingness as it is effectively created by the government. When the government spends it credits electronic bank accounts.

Each $ marked for meeting tax obligations turns purple (for clarity) as it nears the tax leakage part of the loop. A taxed $ simply disappears! Just as government spending adds net financial assets to the economy, government taxation removes them.

If this seems incorrect or counterintuitive, please read on to see it explained in more detail, particularly in the context of treasury debt issuance.

NOTE: This page is relevant for national governments that control their own currencies, do not borrow in other currencies, and do not make their currencies convertible (e.g., to other currencies or gold).

[COMING SOON: Advanced discussion of relationship between the central bank and treasury]

A national government that issues its own currency (like the US and Japan, but not Greece) has what is effectively the option to spend money at any time independently of any taxing or borrowing, even without the "printing press" -- remember, most money is electronic accounting records. Government spending is an INJECTION to the circular flow of spending and income. [?]

The end of gold standard convertibility eliminated the logistical dependency of taxing or borrowing before spending.

(The reasons why countries like the US tax and issue government debt will be discussed later.)

However, some countries do not issue their own currencies -- for example, countries like Greece in the European Currency Union ARE dependent on taxing and/or borrowing before they can spend. In this respect they are just like states within the US.

COMING SOON: Additional details and links examining the topic of government spending independently from borrowing or taxing, as this topic is complex and can get caught up in semantics. Until then, please visit the Macroeconomic Balance Sheet Visualizer and try the 'Government Spends (Consolidated)' and 'Government Spends (Without Borrowing)' operations to see why this assertion about government spending is operationally true, even with the central bank and treasury being separate institutions. But basically, because central banks such as the US Federal Reserve have the unlimited ability to purchase government debt in the secondary market, they never actually have to use this ability, and thus the government never has to actually "print money" in order to have what is effectively an unconstrained spending ability.

Federal taxation is a LEAKAGE from the circular flow. For all practical purposes, the government does NOT need to "save up" via taxing before it can spend! [?]

[COMING SOON: More details on why it doesn't make sense that a government needs to "save up" in the currency that it issues and has control over.]

Until then, please visit the Macroeconomic Balance Sheet Visualizer and observe how the 'Government Taxes' operation leaves the aggregate Federal Government Sector with a negative, not positive, net worth (excluding tangible assets)! This is by design!

Taxes reduce private sector income, leaving less money available for new spending. One purpose of taxes is inflation control. [?]

The purposes of federal taxes are:

To create spending "room" (in terms of freeing up real resources from the private sector) for the politically desirable amount of government spending — which could be small or large.
To limit total aggregate demand (spending) so as to prevent an acceleration of inflation.
To create demand for the government's currency via the requirement that all taxes be paid in that currency. Even if some people decided to pay each other using a private (non-government) currency, they would still owe taxes payable in the government's currency.

Where do the taxed dollars go? We'll revisit this question later, but remember, most money is simply accounting entries in a computer, like points on a scoreboard. The national government as the currency issuer has the power to add and remove "points".

Do government deficits reflect a moral failing and doom our future prosperity? Let's start with the basics. A government deficit is equal to government spending minus taxes. A government surplus occurs in the rare instances when taxes exceed spending.

Additional Information

See Real World Data

If the government spends $5 in a time period (green and red $s)...

...and if it taxes $3 in that time period (purple $s)...

...then the government deficit is $2 (red $s). The deficit is the amount of spending in excess of taxation, in this case $5 minus $3.

Why has the US government been in deficit so much of the last century? Has every Congress been profligate or is something else going on? Deficits play a specific role in the economic machine! HINT: remember the desire of households and businesses for net financial savings?

Inflation measures the rate at which economy-wide prices are increasing. Spending (demand) in excess of productive capacity (supply) puts upward pressure on the inflation rate.

Visual Illustration

Imagine an economy that is near capacity with four $s circulating per year. Next, imagine that the farmer decides to spent an extra four $s from his savings. Because economic capacity (aggregate supply) is not sufficient to produce double the amount of bread, the price level will rise as a way to ration the bread that can be produced!

Click to watch inflation in action, keeping an eye on the price level and inflation gauge as the increased demand (spending) exceeds the capacity of the economy to produce additional output.

You may notice if you keep watching that when the eight $s are re-spent in the second time period, the price level stays at the same heightened level, but inflation drops back to zero. This is because inflation measures price changes from one period to the next, and after the initial surge in spending and inflation, the price level stopped increasing.

See Real World Data

Capacity measures how much an economy can produce. Components include available workers, natural resources, productive capital, etc.

Capacity is represented by the size and efficiency of the water wheel. Increases in productivity and labor force are like technology upgrades that allow the water wheel to produce more output. [?]

Water wheel upgrades: Picture the upgrade path as similar to the historical progression through technology to harness water's power more efficiently and on a larger scale (pictures pending):

From simple wooden constructs used long ago...
to larger wood and metal water wheels for grinding grain in bulk...
to massive turbines in modern hydroelectric dams...
to ??? (technology not yet invented) in the far future.

The price level measures average consumer prices across the economy. Imagine "magical" water with variable density (weight per gallon). If prices rise, the water density falls, thus more water is required to generate the same force on the water wheel as before. [?]

Flawed analogies: Using real world analogies to convey concepts tends to have limitations. The analogy of price level being like the density of the water is flawed. For example, if the price level is rising, in the analogy the water would be getting less dense. The dynamics of the economy would allow an increased quantity of water to flow over the water wheel, such that the total force the flow of water exerts is unaffected and the same economic output can be produced. However, for the analogy to work, you also have to picture a "magic" water wheel that scales in physical size to handle the rising volume of lighter water that corresponds to the rising price level.

An alternate analogy that is less tangible but more precise: Consider a change in the price level to cause a change in the definition of a gallon in terms of how much water it contains. A rising price level would redefine a gallon as a lower quantity of water than it had been previously. If the price level doubled, what had been labeled as one gallon per minute would then be labeled as two gallons per minute, but nothing in the physical reality of the water wheel would have changed.

Press pause to consider a scale comparing gallon buckets:

Inflation measures the rate of change of the price level (e.g., 2% per year). Inflation may rise (e.g., to 3% per year) if the flow of desired spending exceeds the economy's capacity to expand output (i.e., demand exceeds supply). Picture the water's weight per gallon getting lighter over time at an accelerating rate as a "magical" consequence of the imbalance. [?]

Types of inflation: Inflation is a complex and widely misunderstood topic that would be best explained in a separate (future) tutorial. However, in brief, there are two possible drivers of inflationary episodes:

Cost-push inflation is caused by a drop in supply (for example, a sudden shortage of imported oil).
Demand-pull inflation is caused by an increase in demand (for example, a large tax cut in a hypothetical economy that already had very low unemployment would run this risk)

Inflation dynamics result in part from distributional conflicts as workers attempt to negotiate pay raises and businesses struggle to maintain target profit margins. The idea that price level is altered directly by changes in the "quantity of money" is misleading and only a very small part of the story.

One reason inflation tends to have momentum and adjust slowly is because indexation of wage increases to the current level of inflation works to partially perpetuate that level of inflation. Indexation can be a result of government policy (such as social security benefit payments) or conventions in private sector business for how wage raises are determined. (VISUALIZATION OF THIS TO COME LATER!)

"Normal" inflation that is stable (e.g., 2% per year) is not inherently bad, because as consumer prices rise, incomes generally rise at the same time (remember, each dollar spent becomes someone's income!). [?]

Inflation is a complex topic and will be discussed in more detail in a future installment.

While stable inflation isn't automatically bad, it can have distributional impacts as some households and businesses may benefit while others lose out.

Some people also express concern about the effect of inflation on accumulated wealth. Inflation can erode the real value of some types of wealth, but this topic requires additional discussion (pending).

Regarding "erosion of value of the currency", central banks have historically maintained a non-zero short term interest rate that helped savers earn interest on bank deposits to offset the effects of inflation.

Also, the price of the currency (exchange rate) is driven by many more factors than simply changes in price level (link pending).

Households need income in order to spend. But unlike a household, a currency-issuing government can always maintain the national income flow by increasing spending or reducing taxes. The limiting constraint is inflation, never solvency.

Visual Illustration

[COMING SOON: button to show animation]

[COMING SOON: VISUAL: Governor pays brick layer, who buys the extra bread from the baker instead, and no one loses income.]

Additional Details

When government spends a dollar it does NOT take a dollar from anyone else! Remember, money is not a commodity — it is a mostly-electronic financial asset issued by the government and can be created as needed for new spending.

Politics and Public Purpose: The fact that government CAN spend to maintain demand does not mean that it should spend wastefully. (Nor should it bail out failed companies without a very good reason!) Government spending or tax cuts should serve public purpose, though the secondary effects (i.e., what do the beneficiaries of government spending buy with their income?) are generally no longer under government control!

Related topics such as government debt and automatic stabilizers will be covered in upcoming pages.

Consider the scenario earlier in which the private sector (households+businesses) has increased its rate of saving (adding orange $s).

Absent other factors, the flow of spending would fall, with recession a possible outcome.

A government sovereign in its own currency can play a role in maintaining national income flow by increasing its deficit via two methods. First, it has the option (politics permitting) to increase its flow of spending.

Second, government can reduce taxes (a flow leakage), allowing the private sector to keep and spend more income. However, tax cuts may need to be larger to have the same effect as government spending because a portion may be saved.

When is a government deficit too big? The constraint on the size of the deficit is inflation. A government can "crowd out" real resources if a deficit is too large. But even with treasury bond issuance, financial crowding out (with supposed upward pressure on interest rates) is a myth. [?]

Inflation Risk: If desired spending in an economy is too high relative to the economy's capacity, then inflation is likely to rise. The increase in spending could come from a larger government deficit OR from a larger spending desire from households, businesses, or foreigners! For example, an excess of desired spending could push annual inflation from 2% to 4%. Whether this inflationary impulse persists depends on the extent to which a wage-price spiral takes hold. (To be covered in a future tutorial).

Note that hyperinflation is a very different phenomenon that has tended to occur historically only after a large loss of productive capacity.

Financial Crowding Out: Government issuing a larger supply of money and/or bonds in the process of running a larger deficit has no effect on interest rates. COMING SOON: Additional links/explanation.

Solvency: A national government that controls its own non-covertible currency and issues debt denominated in its own currency can never been insolvent, that is, it can never be unable to meet its interest payments! This includes most major nations outside of the European Currency Union — the United States, Japan, Australia, etc. Because such a government can effectively spend independently of the taxes it collects and the bonds it issues, it doesn't rely on the markets to obtain funds for paying interest, either! It can create funds (i.e., financial assets, including bank deposits and reserves) in its own currency as needed. Thus, the market will never price any default risk into the debt of such a nation (unlike nations in the ECU such as Greece!)

The key inflation-related consideration in the context of a growing deficit is availability of unused capacity (most notably unemployed workers). [?]

Hiring the Unemployed: If there is no existing bid for a "resource" (e.g., the long term unemployed), then increased total spending as a result of a larger government deficit generates little overall inflationary pressure. Only if newly hired workers use their wages to buy more food, clothing, etc than they had access to before (e.g., compared to what they could spend from welfare payments or drawing down savings while unemployed) will there be any inflationary impulse, and even then it may be very small.

Crowding out of Real Resources: A government bidding for the scarcest resources (specialized skilled workers, limited commodities such as oil, etc) could add inflationary pressure by competing with the private sector's bid on those same resources. These are sometimes referred to as bottlenecks. In such a situation an important political question is which type of spending (government or private sector) that would employ those resources best serves public purpose.

Combining these insights... Household and business net saving flows are leakages. Government deficits are an injection. They match! (*) That is, deficits as a net injection to the circular flow "fund" the private sector's desire to increase its financial reservoir of net worth!

Visual Illustration

* During any given time period, and ignoring foreign trade for now.

Click to see a continuous circular flow involving government deficit spending, taxes, and ongoing saving by households and businesses.

Without an injection of new dollars in every time period, the private sector (households and businesses) would not be able to add to its net financial savings (orange $s) without causing economic contraction! In this scenario it is government deficits (red $s) that provide the necessary net injection, though as will be shown later, net exports are another potential injection for some countries.

Note: this animation is very simplified. In the real economy, while the private sector is accumulating net financial savings, other flows are likely to be changing in parallel. Thus, GDP would be changing too.

Amazingly, the built in machinery of the economy smooths volatility in GDP (national income) without policy makers lifting a finger. The "automatic stabilizers" increase the government deficit when GDP is falling and reduce the deficit when GDP is rising.

Additional Information

COMING SOON: Graphical depiction of the way in which the savings desires of households and businesses largely determine the government's budget outcome! In other words, as households and businesses choose to save more or less of their income, their actions cause the budget deficit to change size in response!

As a further outcome, the national debt will also automatically increase when participants in the economy demand additional financial savings! Government liabilities (money and treasury bonds) are the only source of net financial savings for a "closed" economy (that is, before accounting for foreign trade).

(Some people consider gold to be money, but they are a minority, and even those people don't generally transact in gold — and they certainly don't pay federal taxes in gold!)

See Real World Data

A large automatic stabilizer results from tax revenue falling when GDP falls, because taxes are a percentage of income. The government spending injection hasn't changed, so the deficit (difference between them) automatically grows.

Another automatic stabilizer is the increase in safety net spending (unemployment insurance, food stamps, social security benefits for early retirees, etc) paid by government during recessions. People who lose income claim benefits, causing government spending and the deficit to both grow.

Automatic stabilizers expand the budget deficit during recessions without any congressional action, limiting the depth of the recessions. Discretionary spending or tax cuts (enacted by policy makers) can further limit the drop in demand.

Conversely, during economic expansions, the automatic stabilizers reduce the threat of inflation by shrinking the budget deficit and slowing the growth in aggregate demand.

What about government debt? Government spending precedes government "borrowing", so a government* running a deficit does not need to worry about finding enough "lenders"! The clearest way of thinking about a government bond is an alternative form of financial savings to money.

Additional Information

* Specifically, currency issuing governments like the US and Japan that issue debt in their own non-convertible currencies and don't borrow in other currencies. Non-convertible means no fixed exchange rate, no gold standard, etc.

COMING SOON: button to show animation of government issuing treasuries (marked using letter T in the reservoir of savings).

The European Currency Union: Countries within the European Currency Union are like states in the United States because they do not issue their own currencies. Thus they DO rely on bond markets and have to tax or borrow before they can spend! [COMING SOON: More detail & links]

When a government such as the US government sells treasuries it is removing money from the private sector and giving the private sector treasury securities instead. Government debt is an asset as well as a liability!

Savings and investment accounts hold a mix of money, treasuries, private sector financial assets (e.g., corporate bonds), and other assets. Money and treasuries are both financial assets, but treasury securities have longer duration (up to thirty years versus "zero" duration for money) and they typically pay a higher interest rate. [?]

Cash and bank deposits are like a checking account at the government, and holdings of treasuries are like a savings account or CD at the government, because they have a longer duration and higher interest rate.

Types of Treasuries: Government treasuries issued by the US government include notes, bills, and bonds. [COMING SOON: More info]

Net Financial Assets: [COMING SOON: Refresher on net financial assets as exclusively provided by government.]

There can be no shortage of "money" available for the government to "borrow"! All money exchanged to treasuries was previously spent into existence by government! Technically such "borrowing" is optional for a national currency issuing government, with some qualifiers. [?]

Government Borrowing: There are laws on the books related to how the treasury and central bank should interact, but in practice they don't matter to real economic outcomes except via politics.

The best evidence of this is the behavior of UK government bond yields compared to that of nations within the European Currency Union. Currency union nations DO need to borrow because they don't control their own currency, so yields on their debt are at the mercy of markets!

Governments also need to issue debt when the central bank's policy interest rate is above zero percent and the central bank is not paying interest on reserves to achieve the target rate. (Links to advanced details pending.)

As shown in earlier pages, households and businesses want to accumulate net financial savings. Thus, there is no such thing as a "buyer's strike" for government debt when a nation controls its own currency and thus has no default risk! Risk-free interest rates are set by the government, not markets*. [?]

* Risk-free Interest Rates: The central bank sets the overnight interest rate on zero maturity assets (bank reserves). All longer term interest rates on government liabilities reflect market expectations about the future path of short term interest rates.

Technically, the markets are setting the actual interest rate on secondary market treasury debt, but the range within these rates can fall is conditioned by expectations of future government policy. Thus government policy indirectly affects the entire spectrum of risk-free rates, from short to long term.

The important implication of this is there is no possibility of "bond vigilantes" collectively demanding higher interest rates and forcing risk-free rates to rise in nations such as the US. Longer duration risk-free rates would only rise quickly if significant changes in the economy and/or central bank policy communications caused expectations of the path of future overnight interest rate settings to shift dramatically.

Interest rates on private sector liabilities such as corporate bonds, bank deposits, bank loans, etc are set directly by the market. However, they are still anchored by the risk-free rate. The interest rate on a car loan, for example, includes the risk-free rate as one component, credit risk (to cover the possibility that the borrower will default) as another component, and a small profit margin for the lender as a third component.

As we saw earlier, money is not a commodity, it is debt, just like treasuries are debt. The government liabilities shown here match the quantity of net financial assets saved by households and businesses in the reservoir below.

Why do governments issue bonds? One reason is a procedural carryover from the gold standard era during which base money (reserve) quantities were constrained by gold holdings. Another is to help manage short term interest rates at a rate higher than 0%. Another is a vehicle for savings. [?]

Treasuries and Short Term Interest Rates: Issuing treasuries is a way for government to help manage interest rate policy. [COMING SOON: More info]

This is the end of Part 2. Click "Next >" again to continue immediately to Part 3 (the last part). Or you may return to it later via the home page tutorial menu. *

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Upcoming Concepts

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Additional Topics

Productivity measures how much output we can produce relative to the resources used. Productivity is driven by innovation and technology, education and skill levels, efficient organizational structures and practices, and more.

Additional Information

Aggregate productivity is one useful measure of the prosperity of a nation, because higher productivity allows us to produce (and consume) more goods and services.

However, neither GDP nor productivity are holistic measures of a nation's prosperity! Economists recognize this, and there are some ongoing efforts to study other measures of well-being and happiness as well.

See Real World Data

Think of how efficiently the water wheel technology (perhaps upgraded to a hydroelectric dam turbine!) can use the water's energy to power production of goods and services, e.g., bread.

Productivity measures the quantity of goods and services that the economy can produce per hour of labor and per unit of natural resources. For example, robots allow factories to produce more per hour of human labor, and innovative crop irrigation uses less water per pound of food grown.

Economy-wide productivity rises over time due to innovation, but individual workers' productivity benefits from experience and suffers under unemployment due to skills loss and hardship!

Full employment (i.e., jobs for people who want them) supports the long term productivity and growth of the economy! One proposal intended to make full employment attainable is the Job Guarantee.

Additional Information

Inflation-Related Considerations: When there are significantly more unemployed workers seeking work than their are job openings [COMING SOON: graph/link], then pool of unemployed workers initially acts to reduce inflationary pressures. This is because those desperate for jobs will often work for lower wages than otherwise.

However, over time the unemployed lose their skills and become disconnected from the economy, sometimes suffering mental illness and moving to permanent disability payments. This reduces their employability in the future and by reducing labor supply may actually lead to higher inflationary pressures than a workforce in which all who wanted to work were able to!

Other workers unable to find jobs may take early retirement benefits, likewise reducing the economy's productive capacity.

These economists consider the job guarantee to be LESS inflationary than high unemployment because it keeps a skilled and connected workforce available for hire by the private sector.

It is also less inflationary than "income guarantee" schemes, because work is required in order to receive the income, which removes any incentive to consume via public funds without contributing at the same time to the productive capacity of the economy.

Output Gap: The output gap measures how far actual GDP is below potential GDP. The gap reflects underutilization and excess unemployment due to a shortfall in aggregate demand. COMING SOON: Graphs

Unintended Consequences? COMING SOON: A discussion of potential types of unintended consequences of such a program, as raised by critics.

Some economists recommend that the government offer a Job Guarantee, i.e., be Employer of Last Resort for those who cannot find work due to insufficient aggregate demand. Pay would be minimum wage but would set a floor on poverty levels and help alleviate the negative social impacts of unemployment.

The result would be "full" employment where all who wanted to work could. Implementation would be at the local community level. It would be a permanent automatic stabilizer, with no congressional micro-management required.

These economists expect a job guarantee to raise the longer term productivity and growth of the economy by reducing the skills loss associated with involuntary unemployment and via workers fulfilling community needs. (Both boost economic "supply")

The added spending by JG workers (via income injected by government) would increase aggregate demand, allowing the private sector to expand and in turn hire workers AWAY from the job guarantee. Economists estimate the number of JG workers would settle at less than 3% of total employment.

When the national government* runs a budget deficit and issues debt, neither taxpayers nor their grandchildren need worry about paying back the debt!

Additional Information

The best future for our grandchildren is one in which the standard of living is as high as possible. Of course there are many other aspects to human prosperity, but productivity is one key economic measure. In thinking about productivity, recall the metaphor of the advancements in water wheel technology discussed earlier.

If high government deficits and growing government debt are needed today for the economy to run near capacity (including close to full employment), then running "big enough" deficits will improve economic prospects for our grandchildren also, as the benefits of full employment and gains in productivity can persist for generations.

The actual size of the national deficit and debt are mostly outside the control of government anyway, given the tendency of the automatic stabilizers to cause deficits to grow or shrink due to the aggregate spending and saving decisions of households and businesses affecting the economy.

So it is best not to focus on the size of the deficit or debt as primary policy targets.

Of course, an important political policy debate is always what types of spending or low taxes are generating the deficits, and whether deficits might be better targeted in order to produce the types of economic output that best serve "public purpose." A financial bail-out out of failed private sector companies, for example, would probably not be a good use of government debt, even though the government can technically "afford" (in purely financial terms) as many bail-outs as it chooses. But there might be some scenarios in which such intervention would be in the best interest of the nation.

* NOTE: This page is relevant for national governments that control their own currencies, do not borrow in other currencies, and do not make their currencies convertible (e.g., to other currencies or gold).

Remember, treasury debt (plus central bank reserves and currency) makes possible our positive NET financial savings. Think of this as total net worth excluding tangible assets -- it could not be above zero for the private sector as a whole without government debt.

We need not plan to repay the debt via higher future taxes! Why take away savings? The concern should be whether future economy- wide demand will exceed future real productive capacity. [?]

If future economy-wide demand is projected to exceed future economic capacity, then there are policy options for limiting the acceleration of inflation.

The optimal policy choices would depend on the specific situation. For example, there are "cost push" and "demand pull" causes of inflation. Automatic stabilizers can do some of the work of inflation control.

If higher taxes turn out to be the best policy choice to limit the acceleration of inflation, those higher taxes should be imposed in the future when the inflation problem is real — not in the present with the idea that the government should start paying back the national debt early! Raising taxes to reduce a deficit in an economy with high unemployment and no current inflation problem risks sabotaguing economic growth and increasing the national debt to GDP ratio.

The US (like Japan) can not become "insolvent" and unable to meet the interest obligation on its debt. It can electronically create interest payments as needed! [?]

Because solvency is never a risk for a country like the US that issues its own non-convertible floating currency, the interest rates on national debt has no "default" risk premium whatsoever.

This is in contrast to countries such as Greece that do not control their own currencies. Once bond market participants start worrying about the solvency of a country like Greece, sovereign interest rates can spiral higher in a sort of self-fulfilling prophecy. The possibility of default can lead to the inevitability of default if there is no willing buyer of last resort.

[COMING SOON: More details & graphs.]

Nor can investors collectively force interest rates higher to "discipline" the government. Because there is no risk of default, risk-free (government) rates will materially rise only if the economic outlook has changed, thereby altering expectations of future short term interest rates.

As the economy expands, the private sector's treasury holdings grow smaller relative to the size of the economy's income (i.e., the debt to GDP ratio falls). Large-enough deficits support this economic growth, with inflation the risk to consider, not solvency!

Is "too much" government debt possible for a nation sovereign in its own currency? Yes, but it's not common. If households and businesses held "too many" treasuries, they might feel wealthier and spend more, with inflation the risk. But the trend would tend to be gradual and smooth rather than sudden and crisis-inducing. [?]

Government Debt and Inflation: Some people are concerned that government debt could cause high future inflation. This could occur under some scenarios, but inflation would be likely to increase in a measured and predictable way with plenty of time for proactive policy response. There would be no reason for a large and sudden rise in inflation unless policy choices generated a very large sudden jump in the national debt at a certain point in time that caused demand (spending desires) to significantly outstrip productive capacity.

Some observers believe that if investors somehow collectively decide that the government debt is too large, then there could be a treasury selling stampede that could itself be the cause of inflation. But the only way such a selling stampede could occur in a sovereign nation that only issues debt in its own non-convertible currency would be if investors had reason to believe the government was planning to default for purely political reasons, and even in that case, the impacts might or might not be inflationary depending on the currency situation.

In general, "excessive" growth of the debt to GDP ratio can be partially self-limiting through (1) automatic stabilizers, and (2) increases in nominal GDP (which is the denominator in debt/GDP) driven in by the inflation that did occur and by real economic growth.

Note that hyperinflation is a very different phenomenon that has tended to occur historically only after a large loss of productive capacity.

Net Exports is a measure of the balance of trade with foreign countries. Exports provide an injection of income from abroad. Imports cause a leakage of income but allow consumption of what other nations produce.

Additional Information

[COMING SOON: button to show animation]

Exchange Rates: Currency exchange rates are driven by many factors including price levels and wages, productivity, interest rates, future growth expectations, and more. There is no relationship as simple as the sometimes cited "quantity of money", nor do currencies spontaneously collapse from a "lack of confidence" without very specific (and uncommon) circumstances. Exchange rates may be covered in more detail in a future tutorial.

Gross Domestic Purchases: When we add the external sector to the flow diagram, the cash register as positioned represents Gross Domestic Purchases. It measures spending by a nation's residents, regardless of where the goods and services are produced — i.e., some of the spending pays for imports. Gross Domestic Purchases differs from GDP (except in the unlikely event that exports and imports are equal).

See Real World Data

The foreign or external sector is all the countries we trade with.

Imports: foreigners let us consume their real goods and services and they accept money as payment.

Exports: we provide real goods and services to foreigners in exchange for money (as income). [?]

Automatic Stabilizer Effects: Exports provide a demand injection that is not directly dependent* on the amount of spending by a nation's residents; instead it is based on spending and investment decisions by foreigners. For this reason, the external sector has some stabilizing effects on GDP just like the government sector, because the trade deficit can automatically expand when domestic spending is falling and vica versa.

(* NOTE: The demand injection from exports likely does have a small dependency on changes in domestic income, because falling purchases of imports reduces the incomes of some foreigners and thus their ability to buy exports. However, most countries trade with many other countries so the DIRECT circular income loops between any two countries are likely to be small relative to GDP.)

Net Exports: the difference between exports and imports. When unemployment is low, exports are a cost (in resources) and imports are a material benefit! [?]

Net Exports Help Fulfill Domestic Savings Desires: An earlier page showed government deficits as the only source of net financial savings available to satisfy the desire of households and businesses to add to their aggregate savings. However, the foreign sector can fill the same role.

The United States and Norway are two contrasting examples. The US generally runs a trade deficit, meaning financial assets "leak" to other countries because the US imports more than it exports, thus government deficits have to fulfill the savings desires of residents AND foreigners. Because of its oil revenue, Norway is an example of a country with a trade surplus, meaning foreigners help Norwegians accumulate net financial savings, reducing the need for the Norwegian government to do so.

Countries compete to export more in order to support domestic employment, though their governments always have the choice to ensure full employment domestically.

A trade surplus (positive net exports) helps fulfill domestic savings desires in the same way that a government deficit is able to. Norway is one example of such a country in this situation.

China doesn't fund the United States government's spending! Americans have bought more Chinese exports than vica versa, and the Chinese choose to buy interest-bearing treasuries using the residual bank balances.

Additional Information

[COMING LATER]

Remember, Net Exports are the difference between exports and imports. If there is a net inflow of goods, there is by definition a corresponding net outflow of funds as payment.

China owns treasuries because the US has bought more goods and services from China than vica versa. China chooses to exchange its residual bank balances for treasuries! [?]

A second reason that China accumulates dollar-denominated assets is that it pegs its currency (the yuan) to the dollar. This means it sometimes buys dollars and sells yuan to hit its desired exchange rate target.

This is a market-mediated asset swap. If the Chinese bought other assets or currencies instead, someone "downstream" in the chain of asset exchanges would buy the treasuries instead. A lower market preference for dollar-denominated assets can cause the dollar's value to fall. This can in turn improve net exports as US goods become relatively cheaper abroad. [?]

An improving trade position (more exports relative to imports) would mean less net financial assets "leaking" abroad. So the effect of "too many" financial assets held abroad can be partially self-limiting; if foreigners don't want to hold the dollar-denominated assets that result from the trade imbalances, the act of selling them for other currencies is likely to shift exchange rates and impact the trade balance in a way that reduces the net leakage of financial assets.

Monetary policy attempts to steer the economy via interest rate changes, but its effects on GDP are mixed and uncertain. Contrary to widespread perception, lowering rates could actually hurt economic growth!

Additional Information

See Real World Data

The central bank sets short term interest rates for the entire economy. Long term interest rates adjust to expectations about future short term interest rates.

Lower interest rates mean lower interest payments on government debt, reducing a source of income and spending of the private sector!

Lower rates can further hurt growth by raising savings rates! This is because it takes more saving to meet targets (such as for retirement) when expected annual returns are lower.

Lower interest rates make it "cheaper" for households and companies to borrow money for consumption or investment. But the effect on GDP is unclear -- we won't usually buy more houses, cars, or factories than we need simply because debt service is cheaper! [?]

During some atypical time periods low rates might have a larger than normal quantity effect on output and GDP. For example, some would argue that low interest rates amplified the recent housing bubble by making "excessive" production of housing inventory more affordable.

More details on credit expansion to come later.

Lower rates also (1) cause distributional shifts between borrowers and lenders and (2) raise the market value of existing debt assets. [?]

Risk-free rates as influenced by central bank policy set the foundation for interest rates across the economy -- including bank loans, corporate bonds, etc. "Foundation" refers to the fact that private sector interest rates add other price factors to interest rates -- the largest being credit/default risk.

After a change in risk free rates across the term structure, the interest rate for new, refinanced, or floating private sector borrowing will adjust accordingly. This causes a distributional shift in how much interest is being transferred from net debtor segments of the private sector to net creditor segments of the private sector.

Another impact of changes in interest rates is a revaluation of existing fixed term debt. For example, lowering interest rates increases the value of existing bonds, because those bonds subsequently pay an above-market interest rate! Thus interest rate shifts also cause temporary changes in nominal portfolio wealth. If certain segments of the population feel wealthier, they might have a slightly higher propensity to spend (and contribute to GDP).

The net effect of changes in interest rates on aggregate demand isn't always predictable. Economists call interest rate policy a "blunt instrument".

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Future Tutorial Topics

This introductory tutorial focused on some of the more important and widely misunderstood core concepts in macroeconomics. Of course, many important topics have been left out, such as private sector debt, financial crises, and much more.

A list of topics for additional future tutorials is on the home page.

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The economy is an incredible machine that can improve our lives. This visual tour of how it works will take you beyond the myths!

In the economy as a whole within any given time period, total spending equals total income. (Think about how each dollar you spend on goods and services is a dollar earned by other people.)

How to Read Additional Details

What if we save instead of spend? Savings are an important component of our total wealth, but they don't participate in the circular flow of income!

Additional Concepts

If we cumulatively begin to save more per time period, then total spending and thus incomes fall. What is virtuous for individuals becomes harmful for the nation, and absent other factors, the result is recession and increased unemployment!

Visual Illustration

Does business investment grow to offset falls in consumer spending? No, investment spending usually shrinks during recessions too! (And most surprisingly of all, even during expansions, investment does not rely on prior savings!)

Additional Information

We've covered the basics on spending, saving, recessions, and business investment and how to visualize them using the water flow metaphor. Let's lay some more groundwork before stepping back to see the illuminating view of how the pieces fit together.

Summary so Far

This is the end of Part 1. Click "Next >" again to continue immediately to Parts 2 and 3. Or you may return to them later via the home page tutorial menu. *

Work In Progress

A national government that controls its own currency can essentially spend at any time by crediting bank accounts and tax by debiting them. (With no need for wheelbarrows of cash or nightmares of inevitable hyperinflation!)

Visual Illustration

Do government deficits reflect a moral failing and doom our future prosperity? Let's start with the basics. A government deficit is equal to government spending minus taxes. A government surplus occurs in the rare instances when taxes exceed spending.

Additional Information

Inflation measures the rate at which economy-wide prices are increasing. Spending (demand) in excess of productive capacity (supply) puts upward pressure on the inflation rate.

Visual Illustration

Households need income in order to spend. But unlike a household, a currency-issuing government can always maintain the national income flow by increasing spending or reducing taxes. The limiting constraint is inflation, never solvency.

Visual Illustration

Additional Details

Combining these insights... Household and business net saving flows are leakages. Government deficits are an injection. They match! (*) That is, deficits as a net injection to the circular flow "fund" the private sector's desire to increase its financial reservoir of net worth!

Visual Illustration

Amazingly, the built in machinery of the economy smooths volatility in GDP (national income) without policy makers lifting a finger. The "automatic stabilizers" increase the government deficit when GDP is falling and reduce the deficit when GDP is rising.

Additional Information

What about government debt? Government spending precedes government "borrowing", so a government* running a deficit does not need to worry about finding enough "lenders"! The clearest way of thinking about a government bond is an alternative form of financial savings to money.

Additional Information

This is the end of Part 2. Click "Next >" again to continue immediately to Part 3 (the last part). Or you may return to it later via the home page tutorial menu. *

Work In Progress

Upcoming Concepts

Productivity measures how much output we can produce relative to the resources used. Productivity is driven by innovation and technology, education and skill levels, efficient organizational structures and practices, and more.

Additional Information

Full employment (i.e., jobs for people who want them) supports the long term productivity and growth of the economy! One proposal intended to make full employment attainable is the Job Guarantee.

Additional Information

When the national government* runs a budget deficit and issues debt, neither taxpayers nor their grandchildren need worry about paying back the debt!

Additional Information

Net Exports is a measure of the balance of trade with foreign countries. Exports provide an injection of income from abroad. Imports cause a leakage of income but allow consumption of what other nations produce.

Additional Information

China doesn't fund the United States government's spending! Americans have bought more Chinese exports than vica versa, and the Chinese choose to buy interest-bearing treasuries using the residual bank balances.

Additional Information

Monetary policy attempts to steer the economy via interest rate changes, but its effects on GDP are mixed and uncertain. Contrary to widespread perception, lowering rates could actually hurt economic growth!

Additional Information

Thanks for visiting! Please consider providing feedback to help improve this tutorial.

Support Econviz.org

Future Tutorial Topics

Next Steps to Learn More

Be Notified of Updates

Theoretical Foundations of this Tutorial

Bibliography and Links

Bank Lending

More Information on Government Deficits and Private Sector Saving

Examples of Government Spending

Real World Data: GDP

Real World Data: Household Wealth in the United States

Real World Data: Recessions in the United States

Real World Data: Business Investment

Real World Data: Federal Government Budget Deficit

Real World Data: Inflation

Real World Data: Sector Financial Balances

Real World Data: Automatic Stabilizers

Real World Data: Productivity

Real World Data: Net Exports for the United States

Real World Data: Interest Rates

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