The Circular Flow of Money
Chart 1

This diagram shows the flow of money payments in the National Income and Product Accounts (NIPA) conceptual perspective. (The actual goods and services purchased by these payments are the implicit but unshown opposite flow.)

Each payment transaction also has two aspects: the spending of the purchaser is the income of the seller. This dual nature of money transactions is the basis for the NIPA's double-entry accounting, and for the basic Keynesian/NIPA macro equation: Spending = Income. They are conceptually equal "by definition." And since NIPA output is measured by what is spent for it, Output = Income.

(However, in measuring total NIPA output and income, the double-counting in intermediate-type transactions is netted out by a "value added" concept. At each stage of production, net output and income (in the form of wages, profit, interest, and rent) is calculated as gross sales income minus taxes and purchases from previous stages of production (if any.)

The Keynesian/NIPA "Achilles heel"

Keynesian theory is conceptually based largely on the NIP accounts (which happened to be in development about the same time). But for comprehensive money-flow analysis, the Keynesian/NIPA system has a dual conceptual and empirical financial gap:

  1. Between saving and investment. It does not show who does the financial saving and how it goes back into the circular flow via business investment and credit-financed consumer consumption.
  2. Between money growth and GDP growth. It does not show how New Money created by the banking system enters the circular flow (as the main means of financing its overall growth), or how it finally exits the circular flow by becoming locked into individual transactors' money-inventory stocks.

Resulting conceptual and analytical anomalies and errors

  1. In the NIPA, "saving" is merely an accounting residual between income and spending, not a directly measurable independent money-flow.

  2. Thus, Keynesian analysis has to resort to confusing, abstract, imprecise, non-empirical concepts like "ex ante/ex post," "propensities," "liquidity preference," and IS/LM curves.

  3. Keynesian theory uses a basically two sector analytical framework: households do the saving and business does the offsetting investment spending. In fact most business investment is internally financed (from depreciation allowances and profits); while households do about as much investment spending as business (for houses, cars and consumer durables), and provide an even larger "outlet" for the economy's financial saving.

  4. To make the NIPA accounts fit Keynesian two-sector theory, household investments in houses are put in the business sector, and household investments in autos, durables and education are implicitly treated as "consumption," (and thus netted against income along with non-durables and services) as are government investments in dams, roads, schools, office buildings, satellites and aircraft carriers.

  5. In Keynesian theory, changes in business investment are the main causes of GDP fluctuations, and have a "multiplier effect." In fact, changes in business investment are largely the result of structural changes in the economy affecting profit prospects. And M1 money growth, largely controlled by the Fed, is the main factor initiating recessions and recoveries, and provides the main multiplier effect.

To the Circular Flow diagram introduction
To the next step, including the Credit Market and Primary Credit Flows
To the complete diagram, including Monetary Authority and sector Money Inventories (M1).

Last revised: September 3, 1999
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