The concept of circular flow in an economy states that the outflows of one economic subject are the incomes of another economic subject. The concept of the circular flows clarifies how expenditures and income affect an economy.
The circular flow model of the economy is a conceptualization of the basic flows of income and spending in the economy during a given period of time. It is usually depicted on a diagram. From the beginning of this textbook, we were able to explain the role and significance of money in any economy. This involves its importance to the consumer (individual), producer and the various tiers of government. As consumers pay for goods and services to producers with money, the later pays the former for their labour/wages in money terms too. The producers also procure their raw materials with money while government incomes that come in form of taxes, fines, fees and prices of services rendered are collected in monetary form. This depicts the fact that money forms the pivot around which the whole economic system revolves.
It’s interesting to note that there are four places where government could be inserted into the model, and each point of intervention is realistic for some markets and not for others. (For example, an income tax could be represented by a government entity being inserted between households and factor markets, and a tax on a producer could be represented by inserting government between firms and goods and services markets.)
In general, the circular-flow model is useful because it informs the creation of the supply and demand model- when discussing the supply and demand for a
good or service, it is appropriate for households to be on the demand side and firms to be on the supply side, but the opposite is true when modelling the supply and demand for labour or another factor of production.
Be that as it may, there’s a double-movement in this diagram: of money, circulating in one direction, and goods, services and factors, circulating in the other. One of the biggest perplexities, when studying (pre-elementary) economics, is the relation between the ‘real’ and the ‘money’ economies.
The issue is this: what do we mean by the creation of value? Starting with the problem that money is at one and the same time a representation of value and value itself. We could find countless locations of the production of subtly different kinds of ‘value’ in this diagram. For instance: isn’t the household – the family unit – considered, at least in certain dominant ways of thinking (which I by no means want to renounce, but…) the locus of the most important values?
Consider, if you want to, that ‘labour’ means not only the work purchased by a capitalist employer, but also the ‘work’ of childbirth. (Some connections here, no doubt, with the previous post on Nabokov…) If we think that life is what we value more than anything else – and, above all, the lives of our loved ones – then the family is the locus of the creation and nurturing of this value.
Plainly, the amount of ‘value’ in the economy can increase and decrease. But we can, provisionally, going along with the unacceptable formulations of vulgar economics, distinguish between two types of ‘value’: real value and monetary value. This isn’t a distinction between the value of money as adjusted for inflation, and the value of money on its own terms. It’s the distinction between the two movements of circular flow: the movement of the ‘real’ economy (goods and services) and the movement of the ‘money’ economy (money).
If the general value in an economy, for example, increases, then there are two forms of ‘production’ here. [We are bracketing off the many different alternative understandings of value – focusing only on the value of commodities/services and the value of money, as economists ask us to]. On the one hand: real production- in production of cars, etc. On the other hand:
monetary production.
The production of money in the financial sector.
In the circular-flow diagram Krugman, Wells and Graddy have chosen to illustrate their textbook, you have [going along with vulgar economics and bracketing out perhaps more pressing and important understandings of the meaning of ‘value’] two locations of the production of value.
i) The firm
ii) The financial sector.
The amount of ‘value’ in the economy can increase in two ways.
i. The production of valuable goods (/services).
ii. The production of money.
What is fascinating and deeply weird is that these two different forms of the production of value are both almost entirely distinct and completely inseparable.
Economic, capitalist value is created by the relation between money and commodities. If you didn’t have a money economy, you wouldn’t have value in the capitalist sense – the economists’ sense – at all. Value as economists understand it can’t be applied to goods in themselves, independent of the mediation of the money economy. But money in itself has no value independent of its relation of representation to ‘real’ value.
The current financial crisis is an example of the production of money running far ahead of the production of commodities – to the point at which the ‘value’ of that money became unsustainable. It was so distant from the ‘real’ value that must (ultimately, in some sense) anchor all ‘monetary’ value. A crisis of overproduction is, perhaps, the opposite: well, ‘money’ value and ‘real’ value must, in some way, event. It can easily underestimate the sheer weirdness of the relation between the ‘money’ and the ‘real’ economies.
In the circular flow of money, you shall be examining the process whereby money payments and receipts of an economy between the households and business sector in form of consumption/expenditure and income/payment and governments are affected and their effects on the entire economy.