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Circular Flow of Funds

Through The Economy

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Circular Flow of Funds

What is Business Finance?

Businesses are, in effect, investment agencies or intermediaries. This is to say that their role is to
raise money from members of the public, and from other investors, and to invest it. Usually,
money will be obtained from the owners of the business (the shareholders) and from long-term
lenders, with some short-term finance being provided by banks (perhaps in the form of
overdrafts), by other financial institutions and by other businesses being prepared to supply
goods or services on credit (trade payables).

Businesses typically invest in real assets such as land, buildings, plant and inventories (or stock),
though they may also invest in financial assets, including making loans to, and buying shares in,
other businesses. People are employed to manage the investments, that is, to do all those things
necessary to create and sell the goods and services in the provision of which the business is
engaged. Surpluses remaining after meeting the costs of operating the business – wages, raw
material costs, and so forth – accrue to the investors.

Of crucial importance to the business will be decisions about the types and quantity of finance to
raise, and the choice of investments to be made. Business finance is the study of how these
financing and investment decisions should be made in theory, and how they are made in practice.
Business finance is a relatively new subject. Until the 1960s it consisted mostly of narrative
accounts of decisions that had been made and how, if identifiable, those decisions had been
reached. More recently, theories of business finance have emerged and been tested so that the
subject now has a firmly based theoretical framework – a framework that stands up pretty well to
testing with real-life events. In other words, the accepted theories that attempt to explain and
predict actual outcomes in business finance broadly succeed in their aim.

Business finance draws from many disciplines. Financing and investment decision making
relates closely to certain aspects of economics, accounting, law, quantitative methods and the
behavioural sciences. Despite the fact that business finance draws what it finds most useful from
other disciplines, it is nonetheless a subject in its own right. Business finance is vital to the
business. Decisions on financing and investment go right to the heart of the business and its
success or failure. This is because:

 Such decisions often involve financial amounts that are very significant to the business
 Once made, such decisions are not easy to reverse, so the business is typically committed
in the long term to a particular type of finance or to a particular investment.

Circular flow of economic activity

Circular Flow of Funds

Definition: Circular flow of economic activity is a theory in economics first observed by JM

Keynes, which suggests that the money and goods in an economy move in a circle fashion
chasing each other indefinitely. In other words, the theory suggests that money and goods from
households go to businesses and then back to the households.

Circular flow model is the basic economic model and it describes the flow of money and
products throughout the economy in a very simplified manner. This model divides the market
into two categories −

 Market of goods and services

 Market for factor of production

The all-pervasive economic problem is that of scarcity which is solved by three institutions (or
decision-making agents) of an economy. They are households (or individuals), firms and
government. They are actively engaged in three economic activities of production, consumption
and exchange of goods and services. These decision-makers act and react in such a manner that
all economic activities move in a circular flow.

The circular flow diagram displays the relationship of resources and money between firms and
households. Every adult individual understands its basic structure from personal experience.
Firms employ workers, who spend their income on goods produced by the firms. This money is
then used to compensate the workers and buy raw materials to make the goods. This is the basic
structure behind the circular flow diagram. Let’s have a look at the following diagram –

Circular Flow of Funds

In the above model, we can see that the firms and the households interact with each other in both
product market as well as factor of production market. The product market is the market where
all the products by the firms are exchanged and factors of production market is where inputs such
as land, labor, capital and resources are exchanged. Households sell their resources to the
businesses in the factor market to earn money. The prices of the resources, the businesses
purchase are “costs”. Business produces goods utilizing the resources provided by the
households, which are then sold in the product market. Households use their incomes to purchase
these goods in the product market. In return for the goods, businesses bring in revenue.


Households are consumers. They may be single-individuals or group of consumers taking a joint
decision regarding consumption. They may also be families. Their ultimate aim is to satisfy the
wants of their members with their limited budgets.

Households are the owners of factors of production—land, labour, capital and entrepreneurial
ability. They sell the services of these factors and receive income in return in the form of rent,
wages, and interest and profit respectively.


Circular Flow of Funds

The term firm is used interchangeably with the term producer in economics. The decision to
manufacture goods and services is taken by a firm. For this purpose, it employs factors of
production and makes payments to their owners. Just as household’s consumer goods and
services to satisfy their wants, similarly firms produce goods and services to make a profit.

Above figure includes the component of the circular flow associated with the flows into and
from the firm sector of an economy. We know that the total flow of dollars from the firm sector
measures the total value of production in an economy. The total flow of dollars into the firm
sector equals total expenditures on GDP. We therefore know that

production = consumption + investment + government purchases + net exports.

This equation is called the national income identity and is the most fundamental relationship in
the national accounts.

By consumption we mean total consumption expenditures by households on final goods and

services. Investment refers to the purchase of goods and services that, in one way or another,
help to produce more output in the future. Government purchases include all purchases of goods
and services by the government. Net exports, which equal exports minus imports, measure the
expenditure flows associated with the rest of the world.

The term ‘firm’ includes joint stock companies like DCM, TISCO etc., public enterprises like
IOC, STC, etc., partnership concerns, cooperative societies, and even small and big trading shops
which do not manufacture the commodities they sell.


The government plays a key role in all types of economic systems—capitalist, socialist and
mixed. In a capitalist economy, the government does not interfere. It simply establishes and
protects property rights. It sets standards for weights and measures, and the monetary system.

In a socialist economy, the role of the government is very extensive. It owns and regulates the
entire production and consumption processes of the economy, and fixes prices of goods and
services. In a mixed economy, the government strengthens the market system.

It removes its defects by regulating the activities of the private sector and by providing
incentives to it. The government also uses resources to produce goods and services itself which
are sold to households and firms. These decision-making agents take economic decisions to
produce goods and services and to exchange them in order to consume them for satisfying the
wants of the whole economy.

Production, consumption and exchange are the three main activities of the economy.
Consumption and production are flows which operate simultaneously and are interrelated and
interdependent. Production leads to consumption and consumption necessitates production.

Circular Flow of Funds

In other words, production is a means (beginning) and consumption is the end of all economic
activities. Both production and consumption, in turn, depend upon exchange. Thus these two
flows are interrelated and interdependent through exchange.

The 4 Factors of Production

There are four types of resources, known as factors of production. Each factor of production has
a unique type of payment associated with it, called factor payments.

1) Labor

These are workers. Payment for labor is called “wages.”

2) Land

This is not just land to rent or own, but is more broadly defined as natural resources. Payment for
land is called “rent.”

3) Capital

This is the money used to buy tools used by the labor to form the land (natural resources) into a
good. Payment for capital is called “interest.”

4) Entrepreneurs

The people who put the other three together, Payment to entrepreneurs is called “profit.”

Financial Markets and Interest Rates

When making a financial decision, you need to know what your options are. Whether you are a
business trying to raise funds, or an investor saving for your retirement, you should know what
the different kinds of stocks and bonds are, how they differ in terms of the interest rates they pay
and the risks they carry, and how the markets where they are bought and sold work. This section
begins by looking at the basic financial instruments: stocks and bonds. We will then go through
though some of the various kinds of stock and bond markets. Finally, we end with one of the key
tools in understanding interest rates - supply and demand.

The Basic Financial Instruments: Stocks and Bonds

Most businesses need to raise funds to expand their operations. The two main ways of doing this
are by issuing either debt or equity.

Debt and Bonds

Bonds are an example of a debt contract. A debt contract is simply a promise to repay an amount
in the future in exchange for funds now. Examples of a debt contract are an IOU or a loan from a

Circular Flow of Funds

bank. A bond is a kind of a debt contract that is marketable, that is it can be bought and sold in a
market. For example, to raise funds, General Motors might sell a bond, which is a promise to
repay the money plus interest some time in the future. While a bond is very much like a loan,
what makes it different is that whoever buys the bond initially can turn around and sell it to
someone else (that is, a bond is negotiable debt, it can be bought and sold).

Bonds generally offer two kinds of payments, a regular payment (generally made every six
months) called a coupon payment and the par value or face value that is paid when the bond
matures (the date when the bond makes its final payments is called the maturity date). Some
kinds of bonds do not have coupon payments and are called zero coupon bonds or discount
bonds. The coupon rate is expressed as a percentage of the face value.

Stocks and Equity

To raise money, General Motors could have also issued stock. In some sense, the process is
pretty much the same. GM offers a piece of paper in exchange for a payment; when bonds and
stock are first offered they both raise money for GM. However, stock differs in two major ways
from bonds. Stock represents ownership in the company so that stockholders can vote on who
manages the company. However, stock does not offer fixed payments like debt, and because of
that, there is higher risk. Some stocks make payments to the owners (which are called dividends)
but they are not guaranteed.

The Capital Market

Sometimes we want to refer to the entire financial sector where demanders and suppliers of
funds get together. We call this the capital market. This is a very general term that gets its name
from the fact that firms are raising funds to make capital projects. It is also a very broad term
since the capital market includes bond markets, stock markets, and the banking system.

Security Exchanges

Once the stock has been purchased in the IPO, the institutions may want to resell them. In fact,
most sales of stock take place after the IPO, in two different kinds of markets. Securities can
either be listed in a stock exchange or sold in an over-the-counter market.

When you buy a stock listed on the New York Stock Exchange (NYSE) typically you would talk
to a stockbroker at a brokerage firm. Brokerage firms are companies that specialize in handling
purchases and sales of stock, along with offering financial advice, and have people on the floor
of the exchange. You would place your order with a broker who would relay the order to a floor
broker (someone who buys and sells on the trading floor). The floor broker would buy the stock
from another floor broker, executing a sell order from another individual.

Circular Flow of Funds

The Money Market

Often investors or businesses will want a place to safely borrow or lend funds for a short period
of time. For example, you may have $40,000 for a payment on a house that you expect to make 2
months from now; you want to earn as much interest as you can on the money, but you also want
to be sure that you don’t lose any of your principle. Or, a business is expecting to get payments
in a month but is facing a cash outflow now and needs short-term financing. One option for both
is to go to a bank and get a short-term loan, or make a short-term deposit. However, bank interest
rates tend to be relatively high for borrowers and low for savers, so when there are large amount
of money at stake, it is becoming more common to take the direct finance path, where borrowers
sell securities to lenders.

Foreign Exchange Markets

There are a variety of different currencies in the world: dollars (US), yen (Japan), euros (nations
of the European Union), among many others. In order to buy goods in Japan you need to
exchange your dollars for yen. While you might go to a bank to do this, banks also need to do
this among themselves. The market where currencies are exchanged is called the foreign
exchange market.

Using Supply and Demand to Understand Changes in Average Interest Rates

In your economic class you probably used supply and demand to understand changes in interest
rates. In this section, we want to review this approach and see how it connects to the rest of the
course. We have said that financial markets connect two kinds of people, suppliers of funds and
demanders of funds. We can represent that relationship in a supply and demand diagram that
shows interest rates and the quantity of funds being exchanged. In this diagram, we are thinking
about the capital market as a whole, so we are including all the different ways suppliers and
demanders can be connected.

The Role of Financial Intermediaries

Financial intermediaries include such institutions as commercial banks, savings banks, savings
and loan associations, life insurance companies, and pension and profit-sharing funds. These
intermediaries purchase primary securities and, in turn, issue their own securities. Thus, they
come between ultimate borrowers and ultimate lenders. In essence, they transform direct
claims—primary securities—into indirect claims—called indirect securities—which differ in
form from direct claims. For example, the primary security that a savings and loan association
purchases is a mortgage; the indirect claim issued is a savings account or certificate of deposit. A
life insurance company, on the other hand, purchases mortgages and bonds and issues life
insurance policies.

Circular Flow of Funds

Financial intermediaries transform funds in such a way as to make them more attractive.8 On one
hand, the indirect security issued to ultimate lenders is more attractive than is a direct, or
primary, security. In particular, these indirect claims are well suited to the small saver. On the
other hand, the ultimate borrower is able to sell its primary securities to a financial intermediary
on more attractive terms than it could if the securities were sold directly to ultimate lenders.
Financial intermediaries provide a variety of services and economies that make the
transformation of claims attractive.

1. Economies of scale. Because financial intermediaries continually are in the business of

purchasing primary securities and selling indirect claims, economies of scale not available to the
borrower or to the individual saver are possible.

2. Divisibility and flexibility. A financial intermediary is able to pool the savings of many
individual savers to purchase primary securities of varying sizes. In particular, it is able to tap
small pockets of savings for ultimate investment in real assets. The offering of indirect securities
of varying size contributes significantly to the attractiveness of financial intermediaries to the
saver. The borrower achieves flexibility in dealing with a financial intermediary as opposed to a
large number of lenders. He is able to obtain terms tailored to his needs more readily.

3. Diversification and risk. By purchasing a number of different primary securities, the

financial intermediary is able to spread risk. If these securities are less than perfectly correlated
with each other, the intermediary is able to reduce the risk associated with fluctuations in value
of principal. The benefits of reduced risk are passed on to the indirect security holders. As a
result, the indirect security provides a higher degree of liquidity to the saver than does a like
commitment to a single primary security. To the extent the individual is unable, because of size
or other reasons, to achieve adequate diversification on his own, the financial intermediation
process is beneficial.

4. Maturity. A financial intermediary is able to transform a primary security of a certain

maturity into indirect securities of different maturities. As a result, the maturities on the primary
and the indirect securities may be more attractive to the ultimate borrower and lender than they
would be if the loan were direct.

5. Expertise and convenience. The financial intermediary is an expert in making purchases of

primary securities and in so doing eliminates the inconvenience to the saver of making direct
purchases. For example, not many individuals are familiar with the intricacies of making a
mortgage loan; they have neither the time nor the inclination to learn. For the most part, they are
happy to let savings and loan associations, commercial banks, savings banks, and life insurance
companies engage in this type of lending and to purchase the indirect securities of these
intermediaries. The financial intermediary is also an expert in dealing with ultimate savers—an
expertise lacking in most borrowers.

Circular Flow of Funds


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