Before I start this, I'd just like to say that if anyone else is/has stud(ying)/(ied) Economics, you're more than welcome to jump in with your own tidbits of information, or if you spot any errors, point them out... for the good of us all.

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Right, in order for this to be workable, we need to slowly build up a model which shows the basics of how an economy works. The first two things that we need to know the definitions of are "consumer" and "producer".

Consumer: Everybody and anybody who spends money on goods or services.
Producer: A firm that provides the goods and services to the consumers.

Using these two definitions, we can already begin to build the most basic of models to show how these two entities in an economy work together.

 Sorry for the crude images, I'm just gonna stick to Paint for these diagrams.

Well, this diagram doesn't show much, atm, all it shows is that the Consumers and Producers are in a constant cycle... but what exactly is it that is cycling around between them?

1 - The producer is producing goods and services for the consumers.
2 - The consumer is paying for the goods and services that the producer has produced.

Now, those two were relatively simple... it's 3 and 4 that start to get a little confusing (made even more confusing by me, in fact... sorry, I should've put the arrows the other way around).

4 - The consumer provides the producer with factors to help aid the production. These factors include things such as land and labour.
3 - The producers pay the consumers in exchange for the provision of the factors on production. Rent for the land, and wages for the labour, for example.

This is the basic model by which the country's economy runs by, and in this model, if you take a sample of value at any point, they should always be the same (in a perfect world, but we'll get into that later).

For example:

 As you can see, if the producer outputs £1,000 worth of goods, then the consumer receives £1,000 worth of goods, and they pay £1,000 for the goods which goes back to the producer, so that the cycle can continue. This is a very basic and perfect model of what should happen in a free market. However, we all know that life isn't perfect, and things don't always play out like the should do in theory.

What if, for whatever reason (which we may or may not get into later) the consumers lose confidence, and they decide that they want to save 20% of their income in case they need that money at a future point in time?

Well, as you can see from this diagram, if a consumer receives £1,000 of income and decides to save 20%, then this means that the producers only end up with £800 which they are able to output the next time. With the consumers still saving 20%, only £640 make it around back to the producers. If output of the economy falls on two consecutive quarters, it is officially labeled as a recession.

Now, you may be asking a couple of questions like: "Consumers save money all the time, how comes we're not always in recession?" "What happens with taxes?" "Imports/Exports?" "What is the effect of credit on this cycle?" I'm going to try and answer these questions now.

Consumers save money all the time, how comes we're not always in recession?

To answer this question, we're going to have to add a whole other sector to the economy. It's quite a famous one... it's been mentioned on the news a lot recently. The financial sector.

For those who don't know, the financial sector is essentially where all the banks, building societies and investment businesses are classified.

Adding the financial sector to our diagram:

The typical consumer would likely store their £200 in a bank, mainly for the interest. Some consumers might chose to keep it under their pillow... that money is essentially lost to the economy until they spend it.

So, what do the banks do with this money? It's simple - they invest it. This investment money is then used by producers to enhance output (money can also be invested elsewhere in the economy, go into later). The idea is that they then pay back the bank more money than what they were given, which they can afford as the investment from the bank has led to them creating more profits. Time to update our model:

As you can see from the diagram, putting money into a healthy financial sector can stimulate economic growth. The problem, at the moment, is that the financial sector made many high risk investments, and many of the firms and people who the risks were made out to ended up defaulting on their loan, which essentially dried up the financial sector's money.

What happens with taxes?

Before we proceed into what effects taxes have on the economy, we first have to realise that any money taken out of the immediate consumer-producer circle is known as a withdrawal from the economy. Putting money into the financial system is a withdrawal from the economy, as is taxation - as it's taking money out of the consumer-producer circle and giving it over to the Government Sector. In the end, though, the money ends up back in the system as it does with the financial system.

5 - Government spending on consumers (welfare, etc).
6 - Government spending on producers (subsidiaries, etc).

Please note that all of these diagrams and descriptions are very simplistic. The Government, for example, also taxes the producers and the financial sector.

Imports/Exports?

Well, again, importing goods is a withdrawal from the economy. Paying firms from other countries for goods or services actually means that the money is getting taken out from the country's economy and put into the economy of the other country. The money is essentially lost. However, the exact opposite is true for exports.

So, of course, the best idea would be to have a healthy balance of imports and exports. What a country loses in importing food could be made up in the export of cars and grasses. Unfortunately, these balances are very hard to get: imports thrive when a currency is strong, and exports thrive when a currency is weak.

What effect does credit have on the economy?

Credit (in terms of consumers) has a positive effect on the growth in an economy. One of the reasons behind the big economic growth of the past decade is the readiness of credit. Consumers could essentially pay firms to produce more and more goods.

Credit is essentially where the financial sector invests money on consumers. This has a very positive effect on the economy in the short term, however, it is much more risky for the financial sector (and, ultimately, the entire economy) to loan to consumers compared to when the financial sector loans its money to firms.

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And that's that, for now. I may extend at a later date, adding diagrams for the last couple of sections, and going into possibilities of why consumers lose confidence, interest and inflation, things like that... but, for now, this is starting to bore me.

Oh, and as I said at the top, if anyone has anything to add I'd be more then happy to add it to this post, as it's for education purposes.

i think i understand, using your model, what would you say is the primary cause of the economic downturn and how would you advocate solving the problem?

 Well, I was going to expand on the article tomorrow adding more information which would help with this (I'm knackered, atm), but to give you a quick summary:

Essentially, all the things in the economy need to be in balance. For the economy to work you need to keep a cycle going.

Income -> Demand -> Output -> Employment (and back around to income).

The cycle failed this time around because income went out of sync with all of the rest (credit died, essentially, which lowered income).

When income lowers, that lowers demand, which lowers output, which lowers employment, which has the continued effect effect of lowering income further.

It's a downward spiral.

For this cycle to turn around, one of the four things much be "swung" around (which, as you can imagine, is a very hard thing to do - as you have the spiralling effect of the other three elements trying to keep it in the same direction).

The Government, thus far, has been tried several things including: (UK)

-Bailing out banks - to increase accessibility of credit, which improves income, and to try to prevent mass layoffs.
-Bailing out automobile industry - this is mainly to try and help prevent mass unemployment
-Dropping VAT - the idea behind this is essentially increase people's real income, so that they can purchase more with their money.

The Bank of England has also dropped interest rates which helps lowers things like mortgages, again helping income.

so are you in favour of new labours economic policy regarding combating the downturn?

or should the goverment do more to support income (cut taxes for the poorer workers) and force the banks to increase output (lending)?

or should the government do nothing and hope the financial sector recovers by itself?

 I personally don't think the Government's gone far enough. IMHO, they should (temporarily, at least) nationalise all banks, and partake in sensible loaning until all of the banks' toxic assets are paid for.

In terms of cutting taxes, it's a terrible idea, imo. VAT is currently as low as it will go due to EU legislation. Also tax cuts can lead to problems in the future when the taxes need to be raised again, rebellion, political suicide, etc.

The financial sector would be able to recover by itself. It's already begun the slow process of healing itself, but that's the very problem, the fact that it's a very slow process.

i definetley agree with you on that one

not to shabby an explanation. Good job.

 Haha, thanks. I just hope this thread doesn't die, this will be my second/third analysis type thread so far, and they all died thanks to hyped trains and people not understanding VGC numbers.

Shame.

OK Sm here's my question and btw very good analysis i might add.
What happens when confidence ebbs out of an economy especially a small economy.
Are your savings safe or could there be a major run on that banking system.
When confidence goes everybody stops spending regardless of income or job security which in effect has a profound effect on said economy.

People start hiding money in case there savings are lost or worse still they lose there shirt on there investments or pensions.
I suppose what I am trying to say is what happens when the bottom falls out of an economy and you find out that the Emperor is actually wearing no clothes.
My analysis is pretty crude but in saying that I don't have any sort of education on economics and am just putting my fears into words.

For me it is the ordinary folks who essentially drive economies with there cash flow.
I mean walk into any bank and the queues of people putting cash in be it for loans or savings are mostly ordinary workers.

I hope I have made some sort of sense in what I am saying as I really am worried about how bad this down turn will be.

Unfortunatley if the thread is not controversial enough it can die.

That doesnt mean the thread was not worth doing imo.