March 23, 2008

Circular Flow Diagram

Filed under: Economics, Vitiated by Ignorance — duncan @ 3:08 pm

Insulting your intelligence again, let me share my latest textbook perplexity. In chapter two (of Krugman, Wells and Graddy’s ‘Economics: European Edition’) I was introduced to ‘the circular-flow diagram’ of the movement of money, goods and services in the economy.  [Sorry about the appallingly ugly images, the result of a hasty google search.  I can’t seem to access the images on Krugman et al’s web page.]

Basic circular flow diagram

Worth noting here, perhaps, the basic institutional divisions. Polanyi would tell us that the market for goods and services is a real market, and that factor markets are in some sense ‘fictional’. I’m not sure I altogether agree with that; but let’s focus on the division between firms and households. One of my longstanding questions is something along the lines of: why does economic liberalism so often ally itself with social illiberalism – why, when we talk of the ‘right’, do we refer both to free market dogmatists and to homophobes, misogynists and racists? I’m no closer to answering that question (or understanding why it’s ill-posed…) but it is perhaps worth noting that the ‘household’ is an institution as important in the creation of this diagram as the ‘firm’.

Be that as it may, there’s a double-movement in this diagram: of money, circulating in one direction, and goods, services and factors, circulating in the other. One of my biggest perplexities, when studying (pre-elementary) economics, is the relation between the ‘real’ and the ‘money’ economies. This perplexity is only heightened when I reach a more sophisticated version of the ‘circular flow’ diagram, in chapter 24.

Circular flow diagram with financial intermediaries

The issue is basically this: what do we mean by the creation of value? I find all this incredibly hard to think through, but let me start with the problem that money is at one and the same time a representation of value and value itself. We could find countless locations of the production of subtly different kinds of ‘value’ in this diagram. For instance: isn’t the household – the family unit – considered, at least in certain dominant ways of thinking (which I by no means want to renounce, but…) the locus of the most important values? Consider, if you want to, that ‘labour’ means not only the work purchased by a capitalist employer, but also the ‘work’ of childbirth. (Some connections here, no doubt, with the previous post on Nabokov…) If we think that life is what we value more than anything else – and, above all, the lives of our loved ones – then the family is the locus of the creation and nurturing of this value.

I think it’s fairly grotesque to write like this: the assimilation of important things to the language of economics, and their misrepresentation in so doing. But I also think…

(The production of commodities by means of commodities. Where commodities = us.)

My specific bafflement, today, is focused on this sentence of my textbook. “By our basic rule of accounting, which says that flows out of any box are equal to flows into the box, the flow of funds out of the markets for goods and services to firms is equal to the total flow of funds into the markets for goods and services from other sectors.” (p. 585). In fact, my bafflement is focused on the first half of the sentence: “By our basic rule of accounting, which says that flows out of any box are equal to flows into the box…”

Surely this ‘basic rule of accounting’ has to be complete nonsense. Our ‘circular flow diagram’ illustrates a closed system. If the flows out of any box in the diagram are equal to the flows into this box (assuming each arrow in the diagram depicts an unchanging quantity [and, I guess, velocity?] of funds) then the amount of ‘funds’ in the system is a constant. This is an economy involving no production (or loss of value). What nonsense.

(I’ve been corrected on this blog before (in a friendly and helpful way 🙂 ), when I’ve complained about elementary textbooks in this way – so I should say that, yes, I know that Krugman, Wells and Graddy don’t actually hold the stupid opinions that their teacher-personas ask us to take seriously. I know they’re being simplistic in the interests of pedagogy. But the bottom line is: don’t lie. If you’re trying to teach a subject, don’t lie. I mean – this lie is completely transparent. It isn’t fooling anyone. Why lie like this? Why treat your readers or students as if you think they’re worse than idiots? One of the strangest and most sinister features of all the education I’ve been subjected to: you progress by demonstrating your willingness to accept falsehoods. Let’s have no more of that, please.)

Plainly, the amount of ‘value’ in the economy can increase and decrease. But we can, provisionally, going along with the unacceptable formulations of vulgar economics, distinguish between two types of ‘value’: real value and monetary value. This isn’t a distinction between the value of money as adjusted for inflation, and the value of money on its own terms. It’s the distinction between the two movements of circular flow: the movement of the ‘real’ economy (goods and services) and the movement of the ‘money’ economy (money).

If the general value in an economy, let’s say, increases, then there are two forms of ‘production’ here. [We are bracketing off the many different alternative understandings of value – focusing only on the value of commodities/services and the value of money, as economists ask us to]. On the one hand: real production. The production of cars, say. On the other hand: monetary production. The production of money, in the financial sector.

In the circular-flow diagram Krugman, Wells and Graddy have chosen to illustrate their textbook, you have [going along with vulgar economics and bracketing out perhaps more pressing and important understandings of the meaning of ‘value’] two locations of the production of value.

1) The firm
2) The financial sector.

The amount of ‘value’ in the economy can increase in two ways.

1) The production of valuable goods (/services)
2) The production of money.

What’s fascinating and deeply weird is that these two different forms of the production of value are both almost entirely distinct and completely inseparable. Economic, capitalist value is created by the relation between money and commodities. If you didn’t have a money economy, you wouldn’t have value in the capitalist sense – the economists’ sense – at all. Value as economists understand it can’t be applied to goods in themselves, independent of the mediation of the money economy. But money in itself has no value independent of its relation of representation to ‘real’ value.

The current financial crisis is, obviously enough, an example of the production of money running far ahead of the production of commodities – to the point at which the ‘value’ of that money became unsustainable, it was so distant from the ‘real’ value that must (ultimately, in some sense) anchor all ‘monetary’ value. A crisis of overproduction is, perhaps, the opposite. [Though I need to do more reading…] So it can be tempting to say: well, ‘money’ value and ‘real’ value must, in some way, eventually, coincide (in the long run). While this reaction is, no doubt, appropriate enough, I think it can easily underestimate the sheer weirdness of the relation between the ‘money’ and the ‘real’ economies.

I, too, find the analogy I’m about to use both pretentious and (more to the point) stupid; but I’m going to use it anyway. If our economy exhibits a ‘circular flow’, this flow isn’t a double-movement in which two separate forms of value travel in opposite directions. It more closely resembles a Moebius strip, in which a single form of value is transformed, by its movement, into its opposite. (And that analogy needs to be immediately abolished, in favour of a less stupid, more helpful formulation.)

Obviously enough, I’m just trying things out for size here. One day, I promise, I’ll know what I’m talking about.


  1. I should be asleep, but I couldn’t resist this:

    why, when we talk of the ‘right’, do we refer both to free market dogmatists and to homophobes, misogynists and racists

    First: I really shouldn’t respond to this now… ;-P

    But second: this particular configuration, of course, is not historically constant (and isn’t uniform within the current historical moment, either, although the question makes sense as a comment on the strange configuration that seems to have gone into forms of “neo-liberalism” in Anglo contexts in the wake of the transformations of the 1970s…).

    But third: strangely, although this configuration isn’t historically constant, there is a sort of logic to it, if you think of “liberalism” philosophically in terms of the distinction between “natural” and “artificial” social institutions, where an “artificial” social institution, in this context, means an institution that is formed by conscious political action, while “natural” institutions are institutions that arise in the absence of such conscious political action – a category that can therefore encompass both things like the “market” (when this is understood as a mechanism for the nonconscious coordination of the consequences of a range of individual actions) as well as things that arise due to “tradition” (or perceived tradition) like the family and even private voluntary organisations of certain sorts…

    My feeling is that this configuration, although by no means historically inevitable, nevertheless does express one of those strange “elective affinities” that do make a certain sort of “social sense”, both in terms of the history of ideas, and in terms of social history…

    Doesn’t make it less irritating, but may make it seem less utterly bizarre… Not sure whether that helps (or is even plausible…)…

    Take care…

    Comment by N Pepperell — March 23, 2008 @ 3:51 pm

  2. And on a more general note: you’ll enjoy Marx’s criticisms of similar issues – the tendency to treat capitalism as a system of distribution/circulation, which among other things renders growth… a bit difficult to grasp…

    One question, just to be kind to the text you’re reading: there’s a reference above to principles of accounting – might this be slightly different to, say, principles that might be invoked in modelling an economic system? In other words, are the claims here bounded and perhaps explicitly intended to express a fairly limited perspective?

    If I weren’t so tired, I would ask something about the way you draw the distinction between money and “real” economies… And also (out of curiosity) whether the term “value” is being used in this text? But too tired to formulate clearly why I’m curious… (Apologies – I should just wait until tomorrow to post, but that would be too rational… ;-P)

    Comment by N Pepperell — March 23, 2008 @ 4:05 pm

  3. Edward Nell has an old essay, “The Revival of Political Economy”. In this essay he contrasts the circular flow diagram with a new diagram. The new diagram illustrates the production of commodities by means of commodities. In particular, capitalists households do not supply markets with produced capital goods, but with savings in the form of money. There has also been some discussion of environmental issues in models of the production of commodities by means of commodities – in particular, in models of joint production.

    Comment by Robert — March 23, 2008 @ 11:14 pm

  4. Sorry it takes me so long to respond.

    Robert – thanks for reading! I’ll try to check out the Nell essay; though I guess I should read, like, Marx, Ricardo, etc. first. So much to read & so little time!

    N. Pepperell – “My feeling is that this configuration, although by no means historically inevitable, nevertheless does express one of those strange “elective affinities” that do make a certain sort of “social sense”, both in terms of the history of ideas, and in terms of social history…” Ah, but why? 🙂 Why these affiliations or affinities, at this time and place?

    On accounting: “are the claims here bounded and perhaps explicitly intended to express a fairly limited perspective?” I guess they might be. The textbook’s claim seems to be that the ‘facts of accounting’ are, as it were, analytic, rather than synthetic. And here my inclination is of course to say that such rules of organisation or description are just as loaded with practical and ideological commitments as the most blunt statement of fact. Someone who looks to be really worth reading is the sociologist Donald Mackenzie – who advocates what he calls “ethnoaccounting”, studying the forms of social life expressed in accounting rules. But your suggestion that I’m reading more into this than I should do is probably accurate…

    Re: “value”. I don’t recall the text foregrounding (or, indeed, mentioning) this word. Basically I’m paraphrasing wildly, being completely unfair to the stuff I’m discussing. First flannel, then apology, then (eventually) nuance – that’s my approach 🙂

    Comment by praxisblog — March 31, 2008 @ 7:03 pm

  5. I actually wasn’t trying to suggest you were reading too much in – just trying to work out the self-understanding of the text itself (if I were less lazy, I would just peek at it myself :-)). It doesn’t invalidate your comments, that this should be a discussion in relation to accounting – it just might help with understanding why certain sorts of positions are taken by the text as plausible – the issue would be one of whether there is some part-object, some fragment of a more complex situation, that, if the text addresses itself to that fragment alone, might render plausible this sort of discourse (something similar applies to your earlier discussion of equilibrium, to which with great disipline I didn’t reply – I try to ration my stalking of your posts ;-P).

    As for this:

    Why these affiliations or affinities, at this time and place?

    That’s what my whole project is about 😉 But I was trying to speak more generically above – to talk about a line of attack for an answer, about a sort of answer, rather than about my personal tilt at this windmill. My personal answer is difficult to condense, but relates to the impact of practicing particular dimensions of our collective lives in a way that manages to mutually differentiate out dimensions that can plausibly be taken as asocial, dimensions that are (plausibly but incorrectly) taken to be social (but intrinsic), and dimensions that tend to be cast as “overtly” social (in the sense of subject to deliberate and conscious political transformation). This sort of enacted structure of social experience can make it plausible, although certainly not inevitable, to separate off what are taken to be asocial or intrinsically social, from “overtly social” dimensions of the context – and then to derive normative standards from the bits of the context that appear timeless and “secure” – so that you tend to get various sorts of criticism of “artificial” bits of the context, from standpoints that claim to be less “artificial”. But the argument is long and complicated – I wasn’t trying to dodge it above, although I don’t know that I can explain my position adequately in any single exchange, but was more just trying to gesture at how the question might be asked…

    Comment by N Pepperell — April 2, 2008 @ 11:04 pm

  6. Your criticims of the stock and flow diagram are well established, having been leveled against François Quesnay and his Tableau Economique as early as the 1770s. But alas the Tableau Economique was published 20 years before Adam Smith’s call for “free markets” in his Wealth of Nations, so I am not sure if it is fair to judge the predecessor concept with criticisms more rightly leveled at the successor one.

    The stock and flow diagram is NOT the “real” economy, simply an economic accounting of some of the major transaction aspects of a “real economy” that occur between producers and consumers. (In that sense, households simply represent consumers and firms are representative of producers.)

    In this model the macro-economy is presumed to be in perfect balance because it makes the model easier to understand; it is not meant to imply that the real economy as whole is actually in perfect balance.

    On the other hand this ‘basic rule of accounting’ is far from being “complete nonsense.” Rather it is fundamental precept in double entry accounting, by convention, debits are made equal to credits so that there is a balance … which can and does occur when the transaction is between two parties.

    Incidentally, other authors do add auxilary variables to change the rate of flows (see Yutaka TAKAHASHI Translation from Natural Language to Stock Flow Diagrams) which serves to convert stock and flow into a more dynamic model; yet even this kind of objective function is just a crude represention of the “real” economy.

    Comment by Eric R — April 11, 2008 @ 5:43 am

  7. Eric – thanks for this. As I hope is clear, I know almost nothing about a lot of what I discuss here; these remarks are more in the way of initial thoughts, as I attempt to educate myself in the basics of economics, than any kind of considered judgement or critique.

    That said – while I understand that the models I refer to in the post are massive and deliberate over-simplifications, I think it can still be legitimate to criticise those over-simplifications; partly because they have real effects (there must be plenty of people in the world whose actions and decisions have substantial political and economic effects who possess only an elementary-textbook-level knowledge of economics); and partly because I think these over-simplifications reveal something about the attitude behind a lot of economic theorising, even when that theorising is whole orders of magnitude more sophisticated and insightful than the textbooks’ models. You say that the macro-economy is assumed to be in balance because this makes the model easier to understand; which is certainly true – by why is this oversimplification chosen, rather than another? Doesn’t this emphasis partly reveal and partly perpetuate a broader emphasis, within economics, on balance rather than imbalance, equilibrium rather than disequilibrium; and doesn’t this emphasis prevent us from properly theorising some of the most distinctive and important features of capitalist economies? This kind of unease is why I’m pushing very hard on the problems I see with these elementary models, rather than just waiting until I’ve read enough to understand more sophisticated theorising.

    On accounting: “this ‘basic rule of accounting’ is far from being ‘complete nonsense.’ Rather it is fundamental precept in double entry accounting, by convention, debits are made equal to credits so that there is a balance… which can and does occur when the transaction is between two parties.” Well okay – I understand the basics of double entry (though the logic behind it does my head in; one of the more important things on my list of things to study properly 🙂 ). But I’m not sure this answers my confusion. For, I think, two reasons:

    1) If, in this massively over-simplified model of the economy, “flows out of any box are equal to flows into the box”, then this economy can’t grow (or shrink). Plainly, economies do grow, which means that somewhere ‘value’ is entering the system. It seems to me (and perhaps I moved onto this point too hastily in the post) that value enters the system in two locations. In the ‘real’ economy, value is produced in firms’ production of commodities. In the ‘money’ economy, value is produced in the financial sector, through the creation of money. But the point is: somewhere flows out of a box are not equal to flows into the box; if they were, there would be a constant and unchangeable amount of value – to use the language of the textbook, a constant and unchangeable level of flow – in the economy. Which there obviously isn’t. That’s what I meant when I said that this ‘basic rule of accounting’ must be nonsense. Somewhere, surely, you’ve got credits without debits, or debits without credits. And I don’t see how the conventions of double entry accounting change that.

    2) On accounting itself (and forgive me for moving into more philosophical terrain); I don’t retain much from my analytic-philosophy education – but I do retain a confidence in Quine’s claim that even analytic propositions – that is, propositions that are true simply by convention – can be proved false (or, in practice, modified) by changes in the real world that the conceptual system these propositions help to constitute aims to describe. So I’m always suspicious when an apparently contentful statement is justified by an appeal to truth by convention. That’s what I meant to (no doubt impenetrably) gesture towards in my comment #4 above; and that’s why I’m interested to read Donald Mckenzie, who from what little I’ve read I gather discusses this aspect of accounting rules (though I think from a Wittgensteinian rather than a Quinian perspective).

    I should say more, but it’s already getting late. Thanks again for your comment. I wish I knew about Quesnay & Yutaka TAKAHASHI; one day, maybe, I’ll be in a position to get round to reading them. 🙂

    Comment by praxisblog — April 11, 2008 @ 8:36 pm

  8. There is a certainty that in a real economy there are some boxes that don’t have equal inputs and outputs. Consider the account book for a person who stumbles on vein of gold while taking a pleasure hike through a mountain range. For him, his ‘costs’ are some walking and either the extraction cost of the gold or how much work he has to do to sell his find, his profits are whatever the gold is worth and the pleasure he derived from the walking, and clearly the two are not equal. This is just a simple example of something that must be accounted for in any economic model: the real value of things found in nature that are not ‘produced’, which is one way the overall value of the economy increases. Another input that simple models do not consider is the value of invention/creativity: the ‘labor’ cost may be insignificant compared to the real value that the invention may add both in terms of new products produced and sold and its social value as something that adds to the quality of life. Because these inputs exist, they also have an impact on the ‘money’ economy – so much so that there have been suggestions that the total amount of money in circulation must be increased to match this added value (which governments frequently do, although to excess, by just printing it). Economies are not static, and any model which attempts to depict them as such will fail miserably if applied to the real world.

    Comment by hyperpat — May 22, 2008 @ 8:34 pm

  9. this topic it needing any activities about it,.

    Comment by papina matangi — February 18, 2009 @ 6:14 am

  10. good information

    Comment by Elias — February 11, 2010 @ 6:33 am

  11. Read von Mises.

    Comment by Charl Heydenrych — January 7, 2011 @ 12:52 pm

  12. Im struggling with grade eleven commercial studies (economics) ,all these statics and simplification of the circular flow are messing with my mind ,anyone willing to help??

    Comment by Sbhayobha — January 19, 2012 @ 5:44 pm

  13. 🙂

    Comment by jazz vince — January 26, 2012 @ 6:46 am

  14. O_0

    Comment by jazz vince — January 26, 2012 @ 6:47 am

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