SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 3)

The Circular Flow of Income, Expenditures, and Funds

by:

Charles Lamson

Firms and households meet in three markets. The circular flow diagram shown in Exhibit 1, pulls together the essential features of this simplified economy. It is designed to highlight the flows of income, expenditures, and funds, which link the various markets to the producing, spending, saving, borrowing, and lending behavior of firms and households.

1. The Circular Flow Diagram

In this simple circular flow diagram, real flows of products and the services of the factors of production go in one direction while, while money flows in payment for the products and the services of the factors of production go in the opposite. Households supply labor and other factors of production to businesses. Money flows from businesses to households in payment for other services of labor and the other factors of production. The payments for factor services are household income. (For simplicity, the only factor we consider is labor.) The wage rate is determined in the labor market by supply and demand.

Households purchase consumer goods and services and new houses from businesses using part of the income they have received in payment for their factor services. Money flows from households back to firms to purchase goods and services. Instead, they are SSUs spending less than what they receive on consumer and investment goods. The financial system links surplus households with DSUs. The DSUs are usually businesses that use the borrowed funds of the SSUs to purchase investment goods.

Funds flow from households (SSUs) to businesses (DSUs) through the financial system, either directly through financial markets, or inherently through financial intermediaries. The interest rate, which equates the quantity supplied of loanable funds from SSUs with the quantity demanded of loanable funds by DSUs, is determined in the loanable funds market by supply and demand. Without highly developed financial markets, transferring the surpluses of SSUs to the DSUs would be much more difficult.

Prices in the output labor, and loanable funds markets adjust to coordinate and balance the supplies and demands resulting from the plans of households and businesses to produce, spend, borrow, and lend. If a change occurs in one market, reflecting changes in the behaviors of households and firms, repercussions will be felt throughout all markets in the form of price and quantity adjustments.

The rules, relationships and inter dependencies that Exhibit 4 (above) depicts can be summarized as follows:

1. The roles of firms: Firms supply goods and services to the product market, demand investment goods supplied by other firms, demand factor services in the factor market, and demand funds (borrow) from the financial system.
2. The roles of households: Households demand goods and services in the product market, , supply factor services in the factor market, and supply funds (lend) to the financial system.
3. The roles of markets: 

• The various markets coordinate and balance the supplies and demands resulting from the plans of firms and households to produce, spend, borrow, lend, and the like.
• A change in supply or demand in one market, reflecting changes in the behavior of firms or households, will have repercussions in the other markets. This means, of course, that the financial system cannot be adequately analyzed in isolation from the other markets.

Recap

The household and business sectors meet in the product market, the factor market, and the financial market. Households demand goods and services, supply, labor, and, in general, supply loanable funds. Businesses supply consumer goods and services, demand investment goods, demand factor inputs, and, in general, demand loanable funds. In the circular flow, real flows go in one direction, while financial flows go in the opposite direction.

*SOURCE: THE FKNANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 65-67*

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