And they found a servant from among Our servants to whom we had given mercy from us and had taught him from Us a [certain] knowledge. (Quran: Al-Kahf: 85)

WRITTEN BY MICHAEL REISS (GUEST AUTHOR) ON JULY 26, 2011.

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.


Figure 1. A (too) simple model of money flows.

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. 

Take a look at Figure 2. This new model now incorporates money creation and destruction. The creation of money occurs as banks make new loans. Money gets destroyed as the principal on those loans gets repaid to banks. The model also incorporates money flows which are used in relation to financial instruments such as shares and bonds, both money used to purchase the instruments and well as money paid out from those instruments such as dividend or coupon payments. This diagram also includes money used for loan interest repayments. Note that, unlike purchasing goods, loan repayments are not paired up with items flowing in the opposite direction; they are simply “fulfilling obligations”.

 

Figure 2. A more realistic model of money flows.

From this more complete model you can now see that the money in the economy is busy doing all sorts of things other than purchasing goods and services. The money supply has to share its flow rate between all these different activities. If there is more flow going to one activity there will clearly be less for everything else.

They key thing to note is what fraction of the money flows is being used for purposes related to the various inflation indices compared to money being used for other purposes which have little to do with the production of goods and services.

If this fraction expands over some period then inflation (as measured by the CPI index, for example) will be high even if the total money supply is constant. Conversely if this fraction shrinks then inflation will be negative (deflation) even if the total money supply is constant.

And confusingly if the changes in this fraction occur at a faster rate than any changes in the money supply, then you can have a state called biflation where there may be inflation occurring at the same time as a fall in the money supply, or deflation with a rising money supply. Few economists understand or have even heard of the concept of biflation and they may get very confused when it is occurring.

Another feature of money flows that we hope this diagram helps illustrate is thatmoney is almost never held for any significant period by anyone, even when people think that are simply holding on to money. For example, when someone goes to “store” money in the bank, the bank will almost immediately use that money, either to buy a financial instrument like a share or bond or to lend it to someone. Money is like a “hot potato” that nobody wants to hold on to. Almost none of it will ever stay in one place for any significant time.

This article was taken from the book What Went Wrong with Economics.

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