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Circular flows in the economy

Lesson in Course: Market movements (beginner, 5min )

The economy is often described as a machine but what makes the gears turn?

Daily transactions we make add up to create our economy. For example, we create an economy when we buy groceries at the store, fill up our cars with gas, buy the latest cell phone, or take out a loan to buy a house. The flow of money through these transactions through the exchange of goods or services drives the economy.

Typically, this flow is circular and starts with spending by a consumer. The money spent by a consumer goes into businesses to be used for production. Companies employ workers for continued production, and the cash flows back into the consumer as wages. The cycle repeats when the consumer spends again. Investors and economists pay attention to news events or developments that affect parts of the flow to anticipate impacts to company earnings and the stock market.

Breaking down the circular flow

To help us become better investors, let's start with spending first and then break down each subsequent part of the cycle.

Spending

When we buy things, we have the choice to spend money in cash or credit. 

When we buy on credit, the amount spent becomes a debt that we must repay in the future. Credit effectively allows us to buy something today but spend cash in the future through debt repayment. Upon our purchase, our transaction shifts the money or credit in our pockets to the seller of the goods, services, or assets.

Example - phase 1

Let’s say we went to the grocery store to buy food. After we make our purchase, the money goes directly to the store. This moves us to the next phase called production.

 

Production

Companies, governments, and other organizations create the goods, services, and financial assets consumers need and purchase.

Once the seller of the goods, services, or assets receives payment, they pay salaries to employees, dividends to investors, and taxes to the government. Of those three cash outlets, two correspond directly to the production of more goods or services and the other is indirect. Salaries and taxes allow the business to continue to operate, while dividends enable the company to attract investors in the future to raise more money for increased operations.

Example - phase 2

Continuing with our example, let’s say it’s payday. The store is paying its employees and the store’s manager is a good friend of ours. The money has now become an income for someone else.

 

Income

We receive income for the contributions we make to production. 

We get paid a salary or commission by our employers, dividends through our investments, or benefit checks from the government for unemployment or Social Security. Whichever the source, our income comes from a producer that received payment from a consumer. 

In the example of financial markets, borrowing money has a similar effect as increasing income—credit creation allows consumers to spend more. 

Example - phase 3

To complete our example, our good friend has now received income for managing the grocery store. The money that we spent at the store has now made its way into our friend’s pockets and they will continue to add to this flow with transactions that they choose to make.

In a functioning economy, one person's spending becomes another person's income and vice versa.

 

The circular flow drives our economy and disruptions to this flow causes changes in the economic cycle. Keep an eye out for improvements in consumer spending, business production, or income growth as these are signals for continued economic expansions. As such, we should expect to see markets rise. Likewise, we need to watch out for the opposite as negative results can cause markets to fall.

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