Circular flow analysis

Every economics text book which I have seen shows a simplified circular flow diagram similar to this:

Traditional circular flow diagram

It shows the transfer of money between different groups in the economy over a fixed period of time. For valid simplification, it ignores the government and foreign sectors at first.

Savings is shown as a leakage from the circular flow, and investment as an injection. Books conclude that preventing contraction of the economy requires private investment to equal savings. For example, "Macroeconomics in Context" by Goodwin et al. contrasts the classical theory of the market for loanable funds, where interest rates equalise savings and investment, with the Keynesian model in which this may not succeed (and therefore a depression can result unless the government supplements aggregate demand).

It seems to me that the model needs some very careful thought before conclusions are drawn.

  1. The diagram appears unbalanced to me: there are no arrows showing the withdrawal of savings, or the repayment of investment loans. In any period of time, while some people are saving some of their income, others are withdrawing some of their earlier savings (e.g. paying for education, mortgage deposit, holiday, etc.). Similarly, while new investments are made from banks to firms, old loans become due, and money flows from firms to banks. I would show withdrawals and repayments explicitly.
  2. Also transfers of money for savings and investment are shown with the same notation as those for household income and consumption spending, even though the latter two immediately complete the interaction between the parties, whereas the former two create a new debt from the recipient to the donor. It would be good to represent this in some way, since there is a fundamental difference between the two situations. The diagram appears to me to model savings and investment as donations.
  3. I would also include consumer loans (and repayments) explicitly. Since the money lent to borrowers is newly created, I believe it is very important to indicate that this increases the amount of money in circulation.

When I think of the circular flow of money in the economy now, it is much closer to this diagram:

Circular flow diagram, showing increases and reductions in debt

For simplicity, it does not show interest payments, and also ignores firms' savings with banks. Those features could be added, but I believe they would be distracting here.

By showing more leakages and injections, this diagram helps to avoid what I now consider the artificial attempt to make investment (the only injection in the original diagram) equal savings (the only leakage). For equilibrium, withdrawals plus lending should equal savings plus repayments. The diagram also challenges the implication that, for example, new savings will exceed withdrawal of previous savings in any particular time period.

Since the purpose of savings is to be able to spend today's earnings later, and since banks insist on being repaid, no market for loanable funds — or government action — is necessary in order to equalise the injections and leakages, at least not in the medium-to-long term, because each of the red arrows generates a debt, obliging the recipient to transfer the same amount of money in the opposite direction (the adjacent light blue arrow) in future. Each leakage and injection is ultimately reversed.

What I believe this shows is that Say's Law is in fact correct over the long term.