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Money and credit - Ivanov V.M.


3.1. Money and Product and Revenue Circuit

The product and income circuit is characterized by quantitative indicators called statistics or stocks. These indicators measure the quantities available at a particular point in time. Such values ​​are expressed without regard to the time interval. Of all the statistics, money is the most important.

There is a definite correlation between the statistical quantity of money and the flow of the national product. This relationship is similar to the relationship between the amount of water in a closed pipe system and the flow of water flowing through these pipes. In monetary terms, this dependence can be expressed by the following equation, known as the equation of exchange:

where M is the statistical amount of money (money supply); V is the velocity of money; PQ - nominal national product; P - price level; Q is a real national product.

The exchange equation is a purely calculated dependence that must always be fulfilled and represents a fairly convenient basis for considering many of the most important problems of economic theory. The influence of changes in the amount of money in circulation on the level of prices and the size of the real national product is extremely important.

Since the majority of savings are accumulated by households, and the majority of investments are made by firms, a certain set of mechanisms is needed by which cash flows are transferred from the first to the second. These mechanisms are created thanks to the functioning of financial markets. Financial markets are depicted in the center of the product and income circuit diagram in Fig. 1.

Financial Markets in the Circuit Model

Fig. 1. Financial markets in the circuit model

When savings and investments are added to this turnover, there are two ways in which funds can “travel” from households to food markets: one — direct, through spending on consumption; the other is indirect, through which funds move through savings, financial markets and investments. The diagram below shows only cash flows. Financial markets consist of many diverse channels through which money flows from the owners of savings to borrowers. These channels can be divided into two main groups.

The first group consists of channels of so-called direct financing, through which funds are transferred directly from the owners of savings to borrowers.

Two subgroups of direct financing methods can be distinguished.

Capital financing - any agreement under which a firm receives funds for investments in exchange for granting the right to share ownership of this firm. The best-known example is the sale by corporations of ordinary ("simple") shares. An ordinary share is a certificate of equity in the ownership of a corporation, giving its owner the right to a share of the profits earned by that corporation.

• Financing by obtaining loans - any agreement under which a firm receives money to invest in exchange for an obligation to pay these funds in the future with an agreed percentage, and the creditor does not receive the right to share ownership of the company. In this case, a well-known example is the sale of bonds, i.e. certificates, which represent obligations to pay a debt over a certain number of years with a percentage, and to do this in accordance with a predetermined schedule. Ordinary stocks, bonds, and some other financial instruments are commonly referred to as securities.

The second group is the channels of so-called indirect financing. With indirect financing, funds moving from households to firms go through special institutions, such as banks, mutual funds, and insurance companies; these organizations are called financial intermediaries.