Money flow and real flow are the two main aspects of the circular flow of income economic model. Both refer to exchanges of goods and services for money, but the two concepts differ in how they refer to the opposite sides of these exchanges as they relate to individuals and companies.
Real flows refer to the flow of the actual goods or services, while money flows refer to the payments for the services (wages, for example) or consumption payments.
Key Takeaways
- Money flows depict the way that money and credit circulate in the economy as income turns into savings and investment and back again.
- Real flows depict the way that commodities and products & services are produced and consumed in the economy.
- While mainstream economists often discount the relationship between real and money flows, many others understand that the two are intrinsically linked.
The Circular Flow of Income
In a modern exchange economy, one in which all economic exchanges involve money, the circular flow of income model attempts to depict the back-and-forth flows of money and services between individuals (or households) and companies.
In explaining the flow of money, this economic model uses the terms "money flow" and "real flow" to designate the nature of the different exchanges that take place.
Within the model, individuals are considered to be both the possessors of factors of production (such as labor, services, or property) and as consumers, the purchasers of goods. Companies are considered to be both the producers of goods and the purchasers of factors of production.
Real Flows vs.Money Flows
Real flows include the factors of production, such as labor or land, that flow from individuals to companies, as well as the flow of goods and services from companies to individuals.
Meanwhile, money flows occur when companies pay wages in return for labor or services provided by individuals, as well as when individuals spend money to obtain goods or services produced by companies.
$5.6 Trillion
The value of the U.S. monetary base as of Oct. 2023.
The Real vs. Money Economy
When mainstream economists speak of the economy, they are most likely referring to the "real" economy—that is, the production and consumption of actual goods and services. In this model, money is merely a "veil" that obscures the actual production economy underlying it, where money serves as a lubricant to make trade and transactions more efficient and less costly.
Other economists, however, such as those in the Keynesian and Monetarist traditions, believe that money and finance are real factors in the economy and cannot be ignored as a simple veil. Karl Marx, writing about capitalism in the 19th century, famously linked the real and money flow together using his conception of M - C - M', where money is converted into commodities (M - C), which are then sold for a profit greater than the money put in (M').
The 2008 financial crisis, which resulted in part from a lack of financial liquidity in credit and money markets, speaks to the importance of the money economy, especially in today's global market.
Why Is Money Flow Opposite to Real Flow?
Money flow and real flow can be seen as the two sides to an equation, so to speak. Real flow focuses on the production of goods and services and the sale of those goods and services to consumers. The real flow goes from companies to consumers. The money flow is the opposite of that; the payment that consumers make to companies for purchasing those goods and services.
Who Controls the Supply of Money?
A country's central bank controls the supply of money. In the U.S., this is the Federal Reserve. It does this by increasing or decreasing the monetary base. The monetary base consists of the supply of money in circulation as well as bank deposits of financial institutions held at the Fed. The way that the Fed controls the supply of money is through open market operations, which is the buying and selling of securities.
Is Depreciation a Flow or a Stock?
Depreciation is a flow because it is an expense accounted over a specific period of time. Due to accounting rules, the expense is not marked at the time of purchase but at the time of use, so an item that is used for multiple years is depreciated over those years; a flow.
The Bottom Line
Both real flows and money flows are part of the circular flow of income model, each being two sides of the model. While real flows focus on goods and services, money flows focus on payments for those goods and services. Most economists focus on real flows, particularly in assessing the financial health of a nation's economy, yet money flows cannot be discounted, given their importance in liquidity.
