A Cash Model of Our Economy

The above picture shows how money moves about the economy. (The government is missing from the picture because of how complicated it would be draw it. Among other things the government takes taxes from consumers, corporations, and investors; gives the money back to consumers in the form of entitlements and wages and gives the money back to corporations through government spending; and also borrows money from investors.)

The blue arrows indicate spending that is included in GDP. This is money that is given to a corporation to create something. The red arrow for imports is subtracted from GDP, because GDP only counts things made in this country not others. The green arrows indicate transactions that are not directly counted in GDP.

Although some people are both consumers and investors, investors tend to invest significantly more than they consume and consumers tend to consume significantly more than they invest. The model is not completely accurate, but should be good enough to teach us some things.

Finally, please note that Foreign Entities also act as investors and make loans to consumers, corporations, and our government. I left it out of the drawing to make the drawing less complicated, but this will become important later.

Background

Before I actually begin, I first want to define a few of the measurements / terms that economists use to indicate the health of the economy. Hopefully this will allow people who have never taken an economics course to better understand the story that I am telling.

GDP (Gross Domestic Product):
The main way that economists measure the health of the economy is to see if our country made more things this year than it did last year. Generally, we are hoping that we create about 3% more stuff each year. If there is a decline in the amount of stuff made for six months (2 quarters), then we say the economy is in a recession. By stuff I am referring to goods (such as food, cars, or houses) and services (such as hair cuts, day care, or internet service).

Economist measure the GDP by measuring how much money four different groups spend on US products:
Consumer - About 70% of the stuff made in the US is bought by US consumers. This makes sense considering there are a lot of people in the US and they spend a lot of money covering every day needs.

Industrial - Corporations play their role by buying computers, manufacturing equipment, and various items to keep their company running.

Government - The government spends money on computers and other office equipment like corporations, but it also spends large amounts on tanks and defense equipment. This is all counted toward GDP.

Exports - Some goods are made in the US and then sold to buyers (Consumers, Industry, or Government) from foreign countries. This is included in US GDP as well.

Current Account Deficit:
It turns out that Americans spend a lot more on products made in foreign countries than foreigners spend on American products. The term current account deficit refers to this imbalance that results in more money flowing out of the country than in. If more money was flowing into the country than out, we would have a current account surplus.

Inflation:
You can probably picture a grandparent or someone else complaining that things cost more now than they used to cost (e.g. When I was kid, movies cost a nickel). Inflation is the term that economists use to describe rising prices.

GDP is measured by looking at the amount of money (US dollars) spent. This can cause problems if the cost of things is rising. For example, imagine a person spent $3 on milk one week and spent $6 on milk the next week. If the price of milk rose from $3 a gallon to $6 a gallon, then that person bought the same amount of milk, but spent twice as much money. When something has been corrected for this problem it is called real (like real GDP) and when it has not been corrected for this problem it is called nominal (like nominal GDP). I almost always be talking about things in real terms because it is more useful.

Unemployment:
The last term is pretty straight forward. The unemployment rate measures the number of people who are looking for jobs, but cannot get them. I may also discuss people who have given up looking for jobs and those who are employed part time but want full time work. These people aren't counted in the unemployment number, but show that there are problems in the economy.