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Circular flows in the economy

Lesson in Course: Market movements (beginner, 5min)

The economy is often described as a machine but what makes the gears turn?

Eureka!

What it's about: Money cycles back and forth between people and businesses through transactions which creates the economy.

Why it's important: Changes to this cycle impact the health of the economy.

Key takeaway: Signs of more spending from consumers and businesses hint at a stronger economy which is usually good for our investments.

Daily transactions we make add up to create the economy. We contribute to the economy when we buy groceries, fill up our cars with gas, buy the latest cell phone, or take out a loan to buy a house. The flow of money through these transactions from buying goods or services drives the economy.

Typically, this flow is circular and starts with spending by a consumer. The money spent by a consumer goes to businesses that use it to pay for production. Companies employ workers to make more stuff, and the cash flows back to the consumer as wages. The cycle repeats as consumers spend again. Investors and economists pay attention to news, events, or developments that affect parts of the flow to anticipate impacts on company earnings and the stock market.

Breaking down the circular flow

Let's start with spending and then walk through each part of the cycle.

At the end of the flow, we should be back to spending

Spending

When we buy things, we have the choice to spend money with cash or credit. When we buy using credit, the amount spent becomes a debt that we must repay in the future. Credit effectively allows us to buy something today but spend cash in the future through debt repayment. Upon purchase, the transaction shifts our money or credit from our pockets to the seller of the goods, services, or assets.

Phase 1

Let’s say we went to the grocery store to buy food. After we make our purchase, the money goes directly to the store. This moves us to the next phase called production.

 

Production

Companies, governments, and other organizations create the goods, services, and financial assets we need and want. 

Money flows back from consumers

Once we pay the seller for stuff, they use that money in 3 ways:

  1. Pay salaries to employees
  2. Pay dividends to investors
  3. Pay taxes to the government

Of those three, salaries and taxes relate directly to producing more goods and services because they are necessary for the business to continue to operate. Paying dividends is indirectly related. It helps the company attract investors so that it can raise more money in the future when it needs to fund increased operations.

Phase 2

Continuing with our example, let’s say it’s payday. The store pays its employees and the store’s manager, who happens to be a good friend of ours. The store has now used our money to pay for production.

Income

We receive income for the contributions we make to production. We get paid a salary or commission by our employers, dividends through our investments, or benefit checks from the government for unemployment or Social Security. Whichever the source, our income comes from a producer that received payment from a consumer. 

Consumers feel the benefit of spending by others

In financial markets, borrowing money has a similar effect as increasing income. Creating credit allows consumers to spend more. 

Phase 3

To complete the cycle, our good friend has received income for managing the grocery store. The money we spent at the store has now made its way into our friend’s pocket, and they will continue this flow with transactions that they choose to make. This starts the cycle over and adds to the economy.

In a well-functioning economy, one person's spending becomes another person's income and vice versa.

 

Actionable ideas

The circular flow drives the economy, and disruptions to this flow cause changes in the economic cycle. Keep an eye out for improvements in consumer spending, business production, or income growth, as these are signals for continued economic expansions. You should expect to see markets rise if you spot these trends. Likewise, watch out for the opposite since negative results can cause markets to fall.

Supplementary materials

Check out this short video that walks through these flows in the economy
https://www.youtube.com/watch?v=de3iGMjA_8c