Money is the lifeblood of modern economies, and its cyclical flow provides a vivid picture of the economy.
The
process of a continual circular flow of an economy's national revenue and expenditure
is referred to as a circular flow of income and expenditure.
We can learn from its research if the economy is running well or whether there is a hiccup in its operation. As a result, the circular flow of money is extremely important for analysing the operation of the economy and assisting the government in developing policy measures.
1. Establishment Producers and Consumers:
The cyclical movement of money creates a link between producers and consumers. Producers acquire the services of the elements of production with money, and the latter, in turn, purchase commodities from the producers.
2. Establishes a Market Network:
As a conclusion to the preceding argument, the connecting of producers and consumers through the circular movement of money has established a network of marketplaces for various commodities and services where issues about their purchase and sale are automatically handled.
3. Tendencies for Inflation and Deflation:
Leakages or injections in the circular flow of money disrupt the economy's smooth operation. Saving, for example, is a leakage from the spending stream.
Saving more money reduces the cyclical flow of money. Given the economy's money supply, this tends to lower employment, income, and prices, resulting in a deflationary trend.
Consumption spending and investment, on the other hand, are injections into the circular flow of money that tend to raise production, employment, income, and prices, leading to inflationary tendencies.
4. Multiplier Basis:
Again, if leakages outnumber injections in the circular flow of money, the entire money supply falls below the total output. This results in a long-term reduction in employment, income, output, and prices.
If, on the other hand, injections into the circular flow of money exceed leakages, the economy's money supply is raised.
This results in a long-term increase in output, employment, income, and pricing. In actuality, the Keynesian multiplier is based on the cumulative fluctuations in the cyclical flow of money.
5. Monetary Policy's Importance:
The study of the circular flow of money also emphasises the necessity of monetary policy in achieving savings and investment equality. The capital market facilitates the equality of saving and investment.
The government controls the capital market through its monetary policies. Deflation or inflation occurs when saving surpasses investment or when investment exceeds saving.
The government controls the loan market through monetary policy. Money and credit policies assist to encourage or delay investment expenditure when saving exceeds investment or investment surpasses saving. This is also how a price drop or rise is regulated.
The monetary policy encourages or discourages investment to control deflationary or inflationary circumstances.
6. Fiscal Policy's Importance:
The circular flow of money also emphasises the significance of fiscal policy.
Saving plus taxes (S+T) must equal investment plus government expenditure (I+G) for the circular flow of money to be in equilibrium.
Savings plus taxes are leakages from the money stream that must be compensated for by injections of investment plus government expenditure into the money stream.
So, if saving plus taxes surpasses investment plus government expenditure deflationary tendencies emerge in the economy, which can be alleviated by fiscal measures such as tax cuts and increased government spending.
On the other hand, if I+G exceeds S+T, the economy is experiencing inflationary tendencies, which may be mitigated by promoting saving and raising government revenues through taxes.
As a result, the cyclical flow of money emphasises the need of implementing compensating fiscal policy.
7. Impact of Trade Policies:
Likewise, imports are leaks in the cyclical flow of money since they are payments made to a foreign country.
To combat it, the government takes steps such as increasing exports and decreasing imports.
As a result, the cyclical movement of money emphasises the need of implementing export promotion and import restriction measures.
8. Accounts for the Flow of Funds:
The cyclical flow of money aids in the calculation of national income based on the flow of funds accounts.
The flow of funds accounts is concerned with all transactions in the economy that are conducted via the transfer of money.
They depict financial transactions across different sectors of the economy, as well as the relationship between saving and investing, as well as lending and borrowing by them.
9. Consequences of Leakages and Inflows:
Understanding the function of leakages allows us to investigate their effects on the national economy.
Imports, for example, represent leakage of revenue from the cyclical flow of income since they are payments made to a foreign country. To prevent this leakage, the government should take necessary measures to promote exports while decreasing imports.
To summarize, the circular movement of money has both theoretical and practical
implications in an economy.
Written By - Tanya C
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