Basic Lecture Notes for Hall and Taylor, Chapter 1

Maintained by: Leigh Tesfatsion
Email: tesfatsi@iastate.edu
Last Updated: 10 August 1996


PLEASE NOTE: These basic lecture notes on Hall and Taylor (HT) Chapter 1 are required for Econ 302. If possible, students should read these notes prior to attending the class lecture on HT chapter 1 on August 29.


Basic References:
HT Chapter 1; Study Guide Chapter 1;
HT Empirical Data Plots (Figures from HT Chapters 1,2).

1. THE ECONOMY AS A CIRCULAR FLOW

Modern industrialized economies are extremely complex---how to get a handle on this complexity?

The standard approach in current mainstream economics is to first try for a "slice in time" picture of the economy by considering who are the key types of economic agents in the economy at a point in time and what are the key types of economic transactions they are engaged in.

Key types of agents in a modern industrialized economy:
Firms, consumers, financial intermediaries (e.g. banks), and government policy-makers.

Key types of economic transactions:
Exchanges of goods and services (physical flows) in return for payments (money flows)


                         Figure 1:
    The Basic Circular Flow Diagram for a Market Economy


     ......... Inputs to Production (e.g. capital and labor) ........
     .                       (Physical Flows)                       .
     .                                                              .
     .                                                              .
     .    ... Income (e.g. wages, profits, interest, rent) ...      .
     .    .                (Money Flows)                     .      .
     .    .                                                  .      .
 ....\/........                                        ......\/.........
 .             ....Final......                         .                .
 .    Firms    . Investment  .                         .   Households   .
 .             <....Goods.....                         .                .
 ..............                                        ..................
     .   /\                                                 .      /\
     .    ..................  Expenditures  .................       .
     .                        (Money Flows)                         .
     .                                                              .
     ....................Final Goods and Services ...................
                             (Physical Flows)



                           Figure 2
      Figure 1 Extended to Include Financial Intermediaries


       ...... Inputs to Production (e.g. capital and labor) ...
       .                    (Physical Flows)                  .
       .                                                      .
       .                                                      .
       .  .......  Income (e.g. wages, profits,...)  .......  .
       .  .                 (Money Flows)                  .  .
       .  .                                                .  .
 .....\/........                                       ....\/............
 .             ....Final......                         .                .
 .  Business   .  Investment .                         .   Household    .
 .   Sector    <....Goods.....                         .     Sector     .
 ...............                                      ..................
  /\   .  /\                                               .  /\      .
  .    .   .................. Expenditures  ................  .       .
  .    .                      (Money Flows)                   .       .
  .    .                                                      .       .
  .    ..................Final Goods and Services..............       .
  .                          (Physical Flows)                         .
  .                                                           Personal.
  .                                                           Savings .
  .                                                           (Net)   .
  .                                                                   .
  .                                                                   .
  .                                                                   .
  .                                                                   .
  .                                                                   .
  .    Investment       .............................                 .
  .    Loans (Net)      .                           .                 .
  ....................... Financial Intermediaries  < ..................
                        .      (e.g. Banks)         .
                        .............................


                            Fig 3
  Fig 2 Extended to Include Government and a Foreign Sector

                        -----------------------------
                        |    Rest-of-the-World      |    ROW Savings (Net)
                        |          (ROW)            |..........................
                        |                           |                         .
           Exports      -/\----.---------------------                         .
   .......................     .                                              .
   . ...........................                                              .
   . .     Imports                                                            .
   . .                                                                        .
   . .  ...... Inputs to Production (e.g. capital and labor).........         .
   . .  .                    (Physical Flows)                       .         .
   . .  .                                                           .         .
   . .  .                                                           .         .
   . .  .  ........ Income (e.g. wages, profits,...)........        .         .
   . .  .  .                 (Money Flows)                 .        .         .
   . .  .  .                                               .        .         .
 --.-\/-\/-.----                                       ---\/--------.----     .
 |             |....Final......                        |                |     .
 |  Business   |  Investment  .                        |   Household    |     .
 |   Sector    <....Goods......                        |     Sector     |     .
 /\/\--.-.---/\                                       --.--/\---.-/\-.--     .
  . .  . .   .                                           .   .   . .  .       .
  . .  . .   .................Expenditures................   .   . .  .       .
  . .  . .                    (Money Flows)                  .   . .  .       .
  . .  . .                                                   .   . .  .       .
  . .  . ................Final Goods and Services.............   . .  .       .
  . .  .                     (Physical Flows)                    . .  .       .
  . .  .    Business Taxes,                    Personal Taxes,   . .  .       .
  . .  . Final Goods, Services -------------    Labor Services   . .  .       .
  . . ........................>             <.................... .  .       .
  . ...........................  Government|........................  .       .
  .    Govt Expenditures       -------.-----    Salaries/Transfers    .       .
  .  on Final Goods and Services      .                               .       .
  .                             Govt  .                       Personal.       .
  .                           Saving  .                       Savings .       .
  .   Investment        --------------\/------------          (Net)   .       .
  .   Loans (Net)       |                          |                  .       .
  ......................| Financial Intermediaries <..................\/.......
                        |    (e.g. Banks)          |
                        ----------------------------

2. AGGREGATE DEMAND AND SUPPLY ANALYSIS

The circular flow figures 1-3 above give us a view of a modern industrialized economy at a given point in time in terms of its principal types of economic agents and the transactions which interconnect them. A useful alternative way to view the economy at a point in time is through its market structure. Hall and Taylor (HT) follow the latter approach. As we will see in subsequent chapters, the HT model of a macroeconomy at a point in time consists of three interrelated markets for goods, money (financial assets), and labor from which are derived economy-wide aggregate demand and supply curves.

In addition, HT recognize that many of our most pressing economic problems concern dynamic aspects of the economy. How fast is the economy growing over time in terms of the production of goods and services? How fast are incomes growing over time? Is there a danger that the inflation rate will get out of hand? What, if anything, should government do to encourage more growth? to lower unemployment? to reduce inflation?

HT provide numerous figures in Chapters 1 and 2 depicting key "macro time series data" for the U.S.---that is, graphical plots depicting the way key macro data (output, prices, the inflation rate, etc.) have varied over time for the U.S. These plots reveal various dynamic regularities and anomolies exhibited by the U.S. economy in recent times and help to clarify the basic empirical issues that are driving current macroeconomic debates (particularly heated in this presidential election year!) regarding the proper role of government in a decentralized market economy.

In an attempt to get a handle on these dynamic aspects, HT introduce into their model dynamic adjustment relations for prices and quantities. Specifically, the general price level is assumed to adjust slowly over time in response to deviations between aggregate demand and supply for goods and services. The resulting dynamic macroeconomic model, while highly simplified, is nevertheless instructive in that it provides a way for students to begin to think more carefully about the possible dynamic effects of alternative fiscal (tax and expenditure) and monetary (money supply) government policies.