Many economics textbooks include diagrams to show how money flows within an economy. The diagrams almost invariably show the different groups (banks, industry, government etc.) in fixed locations with the money flowing from one group to another. While these diagrams may be useful in some senses, they usually fail to convey some important characteristics of money flows.
In this section I will present an unconventional way of thinking about the flow of money. Imagine the act of money being used to purchase a good or service (hereafter given the single label “good” for simplicity) to be akin to two people crossing the road in opposite directions. Imagine the money starting out on the left-hand side of the road and the good being purchased starting out on the right. The exchange occurs when the money passes the good heading in the opposite direction. The money and the good will always cross in pairs at the same time. Now imagine this on a larger scale. You could visualise all the transfers of money for goods in the entire economy being carried out on a long stretch of road, with all the money that exists lined up on the left-hand side and all the items ready for sale lined up on the right. You could now observe a series of paired-up “swaps” of money for goods occurring along the road.
One apparent problem with this visualisation is that, as stated so far, all the money that exists would end up on the right-hand side of the road and no money would be left for any further purchasing. We can fix this by simply imagining some underpass whereby money can instantly travel from the right-hand side of the road back to the left, so that all the money that exists is always available to be used for purchasing.
The visualisation is far from complete, but it is useful to pause and consider what we have so far. See Figure 1.
This simple mental model appears to be thebasis of many theories about money flows and inflation. For example, the diagram makes it clear that the flow of money mirrors the flow of goods. This “mirroring” can be expressed mathematically in the equation of exchange (MV=PT) which you will see described in almost all economics textbooks. This equation states that the amount of money in the economy (M) times its rate of flow (V) equals the rate of sales of goods (T) multiplied by the average price of those goods (P).
Unfortunately this visualisation of money flows as described so far is slightly too simple. It has led to some serious errors and confusion.
A more correct model requires the inclusion of a variety of additional money flows. This risks making the diagram rather complex, so for clarity the goods flowing from right to left are not shown. (more…)