Go with the flow! Why teaching the circular flow model is so important

Go with the flow! Why teaching the circular flow model is so important

flow chartLike many other subject areas these days—biology, history, and government, to name just a few—the study of economics can become politically charged faster than you can say "Ricardian equivalence theorem." Considering some of the language commonly employed in the media and in political debate, a beginning economics student could not be blamed for thinking that our economic system is essentially a war between "us" and "them." "Them," of course, is whoever disagrees with "us."

Teachers can help remediate the pervasive "us-versus-them" mentality by introducing the circular flow model of the economy early in a social studies or economics class. Teachers describing the major segments of the domestic and global economy in objective terms can show how they are actually interdependent and not at war with each other.

A two-year assessment by outside experts of the Atlanta Fed's education program found that teachers' confidence in their ability to teach about money and the banking system was particularly weak. The three-factor model, as explained below, can provide a useful tool to help teachers navigate through this complex topic.

A basic three-factor model
Click on interactive chart 1 to see how businesses (source of production) need households to supply labor, and in exchange, the businesses return income (rewards) to the households. At the same time, households need and are willing to pay for the goods and services that business provide.

This three-factor model includes the government sector, which collects taxes from businesses and households and provides goods and services (things like national security, natural disaster aid, justice, transportation, environmental and consumer protection, education, partial funding of workers' retirement and retirement health care, and regulation) that benefit the common good. Since the founding of the republic, the debate has raged about how large a role government should play in the economy, but over time and through painful experience, voters have supported some role for the government in providing these goods and services.

Teachers can show students the flow of money, resources, goods, and services among the three factors. Several simple and entertaining lessons and activities are available to help students experience how this flow works in the classroom or in their own personal lives.

See the Share the Wealth section of this issue of Extra Credit for more specific lessons and strategies from three Atlanta area teachers on teaching the circular flow.

Adding the financial sector
Chart 1 also illustrates circular flow with the financial sector, which can help the teacher show how households put savings into the financial system, and those savings end up providing funding (in the form of lending) to businesses so they can expand, hire more workers, and produce more and better-quality goods and services. Households receive income from their investments, which they can use to save for future needs or spend on more immediate needs.

Teachers can show that without the banks and other components of the financial system, consumers and businesses would find it much harder to get funding for projects and the economy would not be able to continue to grow.

In fact, during the financial crisis of 2008–9, the flow of credit through the financial system very nearly froze up. Essentially, when subprime and other types of loans began to go delinquent and default, banks and other financial institutions that held securitized packages of these loans became unwilling to lend to each other in the short-term markets.

When the liquidity of some major default insurance providers was also questioned, credit availability tightened even more. Chart 2 shows that the flow of short-term credit funding of things like credit card loans, student loans, auto loans, and home equity loans, which had been running at a rate of about $300 billion per month, fell to nearly zero in October 2008. The commercial paper market, on which many businesses rely for their short-term funding, also nearly shut down. As a result, some businesses may have been dangerously close to not being able to make payroll, extend credit, or meet other obligations.

Admittedly, a detailed discussion of credit markets is more likely to occur in advanced economics courses, but teachers can introduce the basic concept of how the financial markets participate directly in the everyday activities of businesses and households in the context of the circular flow model.

As many of us recall, Congress initially voted down the $700 billion rescue plan and the Dow Jones Industrial Average fell nearly 800 points on Sept. 29, 2008, erasing about $1.2 trillion from the market value of U.S. shares. Political and media rhetoric at the time was heated, sometimes over-heated, with at least some of it due to misunderstandings or mischaracterizations of the financial sector's role in the overall economy.

In advanced courses, teachers can challenge students to go deeper into issues like how the housing bubble, low consumer financial literacy, abuses by financial players, regulatory lapses, and political factors may have played into the crisis. If students start with a solid foundation in the circular flow model, however, they can at least begin with a balanced and objective understanding of how the various components of the economy work together.

September 6, 2011