THE CIRCULAR FLOW MODEL

THE CIRCULAR FLOW MODEL

To analyse an economy as a whole it is useful to start with a breakdown
of society into households and firms. Households on one
hand act as consumers of all final goods and services; they also act
as owners and providers of land, labour, capital and enterprise: an
economy’s productive resources. Firms, in contrast, act as the
© 2004 Tony Cleaver
suppliers of consumer goods and also as the employers of all
resources. Households and firms, employment of resources and the
demand and supply of all consumer goods and services are all linked
together in one nation-wide circular flow as illustrated in Figure 4.1.
Note that the top half of the Figure 4.1 illustrates a market for
all consumer goods and services: money and goods are exchanged
between buyers and sellers; and the bottom half represents the
market place for factors of production: where employers pay for the
productive resources they wish to hire.
Money flows around the economy therefore in the direction of
the arrows – in the form of spending on consumer goods and services
in the top loop, and in the form of incomes exchanging for the
hire of resources in the bottom loop.
There is a qualification we need to make to this national circular
flow, however. Not all household income is immediately spent on
CONSUMPTION. Some fraction may be saved and, of course, some
percentage of income is always taxed away by governments.
For the time being we can ignore the influence of government
taxes and concentrate on what happens to SAVINGS – all money not
spent. Where does income saved actually go?
Consumption spending
Households Firms
to land, labour, capital and enterprise Incomes from work
Figure 4.1 The circular flow of incomes and consumption.
© 2004 Tony Cleaver
In modern, financially sophisticated economies, much of those
savings will go into banks. Nowadays a variety of commercial
financial institutions have evolved to hold your savings in one form
or another – private banks, building societies, savings-and-loans
institutions, unit trusts and pension funds. The more trustworthy
the financial infrastructure in an economy, the higher a fraction of
a nation’s savings will find its way into these accounts.
The corollary of this for less developed countries is, of course,
that a much lower fraction of the nation’s savings will be re-cycled
into financial institutions. It is not so customary to deposit hardwon
incomes in less well-understood banks and commercial houses;
and savings may not always be in money form but stored in the
Box 4.1 Informal finance
Much economic activity in poor countries comes from what is
called the INFORMAL SECTOR – small-scale enterprise, unlicensed,
unrecognised and operating for the most part beyond the protection
of the law. This sector includes small farmers, artisans,
independent traders and a whole host of self-employed who
operate in rural and urban settings with whatever funds they can
command. Any savings from this sub-economy are in the form of
goods and services in kind, promises of support that might be
called on in the future, rarely in unspent revenues. On the other
hand, credit needed to re-stock, or hire simple equipment must
come from informal moneylenders, pawnbrokers, or larger landlords
who can charge exorbitant rates of interest on loans. There
is no formal banking system that can cater for such small-scale
operations that are spread across the entire country – the administration
and information costs of serving such a clientele are
prohibitive, given the small turnovers involved. Aggregate
production can nonetheless be great in total – representing
between a third and a half of national income in some cases. But
as a result of such fragmented and missing financial markets in
poor countries, informal savings cannot be easily recycled to
meet investment needs. This is a major obstacle to development,
as will be seen.
© 2004 Tony Cleaver
form of local produce or even in promises owed by friends, family
and associates.
In the developed world, national savings rates may be relatively
high and the great bulk of these funds flow into formal financial
institutions. In poorer countries, not only will the percentage of
national income saved be lower but also much saving will not find
its way into the formal banking sector at all (Box 4.1).
In the circular flow diagram illustrated in Figure 4.2, all savings
represent a leakage from the system – a decision to postpone
current consumption. Insofar as these savings are placed in financial
institutions there is the possibility, however, that these funds can be
recycled back into the national economy: banks make loans to firms
in order to fund INVESTMENT.
For the sake of simplicity, we need to consider only bank loans
which finance industrial investment (in reality, many savings go to
finance consumption but we can ignore these and assume these
funds never left the circular flow in the first place). The issue that is
important for macroeconomic purposes is what happens if the flow
of savings which leak out of the system on the one hand does not
equal investment which is injected back into the economy on the
other. There is, after all, no reason why these two flows should be
equal since they represent decisions by very different people and
institutions in the community.
Figure 4.2 Savings and investment in the circular flow.
Households Firms
Financial intermediaries
Savings Investment
Consumption spending
Incomes
© 2004 Tony Cleaver
It should be seen that, as in any fluid system, if the LEAKAGES
from the flow are just a little more than INJECTIONS then the aggregate
level of money and incomes circulating the economy must
slowly decline. Conversely, if injections into the flow are larger
than leakages, aggregate incomes must rise over time.
We can begin to see here the illustration of what Keynes called
the PARADOX OF THRIFT: that, although saving seems to be a virtue for
the individual, if a whole community saves then aggregate incomes
fall. There is no guarantee that national income will remain stable,
therefore, so long as savings and investment are out of line.
Free market economics is not so easily confounded, though. It is
asserted that a country’s banks act as FINANCIAL INTERMEDIARIES –
dedicated to matching up savings on the one hand with loans (for
investment) on the other. What happens if these two flows do not
equal each other? Banks in a free market will set into operation the
price mechanism to ensure financial, and thereby national, equilibrium.
We return to the operation of demand and supply that was
analysed before.
Check Figure 4.3 overleaf. Consider that savings represent the
supply of funds into financial markets; loans that go to facilitate business
investment represent the demand for funds. If supply exceeds
demand the price of funds will fall. Conversely, if demand exceeds
supply the price of funds will rise. Changes in the price of money –
known as the market rate of interest – act like prices in the market
for oranges, or coffee, to ensure that there is always equilibrium.
According to mainstream, or NEOCLASSICAL ECONOMICS, the
supply of savings in a country rises as the rate of interest (the
reward for saving) increases. Conversely, the demand for funds for
investment will fall if borrowers have to pay too high a price. The
two conflicting objectives meet at the market equilibrium rate r*
where the aggregate total of savings just equals the aggregate total
of investment at q*.
What happens if there is an exogenous rise in the country’s
savings S to S1? The equilibrium rate of interest will fall to r** so
that there is no occasion when leakages and injections to the
national income are not equal.
In this case, therefore, financial markets play an enormously
important role in the national economy – adjusting interest rates in
order to secure balance between leakages and injections into the
© 2004 Tony Cleaver
flow of incomes, between savings and investment, so that the
economy as a whole experiences neither INFLATION nor RECESSION;
neither boom nor bust. With flexible markets, therefore, the
economy as a whole attains general equilibrium at full employment
where the aggregate supply of goods and services creates just sufficient
income to generate an equal and opposite aggregate demand.