A money economy is basically characterised by the circular flow of money. It involves a continuous flow of money payments in its economic activities. Modern economic life is interdependent.
Thus, in the want- satisfying activity, goods produced by one are exchanged for the consumption of the other. There are, thus, two major classes in the economic process. These are: producers (or firms) and consumers (or households).
The portion of money income, which the consumers spend on the purchases of goods and services in an economy, passes through the hands of many people the retailers, wholesalers and manufacturers, i.e., the producer class.
These producers then again use money in investments and it thus passes to the consumers in the form of wages, salaries, interest, rent, profit, etc. In short, there is a circular flow of money between firms and households (in a closed economy).
As a matter of fact, there are real flows and monetary counter-flows. In a simple two-sector (firms and households) closed economy model, thus, the real flows constitute the movement of productive factor resources from the households sector to firms, while real output (finished products) of the firms move to the household.
In a barter economy, money being used as a medium of exchange, there are monetary payments involved behind real transactions. Thus, there are “monetary counter flows” to the “real flows”, which being circular in movement constitute the “circular flow of money”.
Thus, money flows from firms to households, when firms purchase factor services and, to that extent, firms’ spending determines the income of the owners of factors of production comprising the household sector.
To state in elaborate terms, the firm pays the prices to the factors of production while employing them into the productive channels. This constitutes the cost of production which in turn becomes the income of households.
Thus, in an aggregate sense, the value of national income can be viewed in terms of factor cost or factors’ earnings in total. Similarly, when households spend on real output produced by firms, real goods and services flow from firms to households while money flows from households to firms.
What household spend on firms’ products is equivalent to the prices of products which indicate the value of real output turned out by the firms. Thus, the value of national product can be measured by aggregating their market prices.
Continuous or unchanged real flows and money flows in an economy would imply that the same amount of goods and services are produced at constant prices over a period of time.
Thus, the main condition of constant prices is that the flow of goods and services should remain intact and there should be no leakage of money in its circular flows, i.e., whatever has been paid out to households by the firms should come back through their consumption expenditure.
In the above given very simple model of circular flow, we may now incorporate a saving element (which implies a sort of leakage from the flow of income-expenditure).
Saving is the unconsumed part of income or unspent money left with households. If the savings of households are not hoarded but made available to the loan-able funds market i.e., capital market, the businessmen (firms) can borrow them for investment purposes.
When saving tends to be equal to investment or vice versa and the circular flow of money remaining undisturbed, economic activity and the price level would remain constant in the economy.
It is obvious that the circular flow of money would remain undisturbed if the flow of funds into the capital market (i.e., savings) and the flow of funds out of the capital market (i.e., investments) are equal.
Any disequilibrium in the savings and investments, of course, will reflect itself either in the decrease or increase in the circular flow of money.