The circularity of economic processes

The classical idea of the reproduction of a social division of labor has a built- in circularity. As we saw in Chapter 2, the classical theory treats the output of each individual production process as inputs into other processes.

Figure 2. The circular flow without government

order to construct an image of the flow, then, we must combine individual decisions (microeconomics) with aggregate flows (macroeconomics).

Figure 2 presents a simplified image of the circular flow. It ignores both the government sector (taxation, government spending, transfer payments, and government debt) and the possibility of international trade. Without government, individuals’ incomes depend entirely on the amount and kind of property they own. Property in labor services can be sold to firms for a wage. The exchange of labor for a wage (or salary) makes up the primary source of individual (or consumer) income. Property in capital also yields income in the form of interest, dividends, and capital gains.

Aside from the flows into and out of the financial sector, the circular flow consists of movements of goods in one direction and of money in the other. Flows into, out of, and within the financial circulation consist of money and financial assets (stocks, bonds, and private debt). Money plays a primary part in the circular flow when we consider its stability or instability and, for this reason, it is important to bear in mind the monetary nature of all move­ments within the flow..

Within the circular flow as depicted in Figure 2, the movements indicated by solid lines make up a closed circuit. They connect those aspects of the entire movement that are genuinely circular. The movements indicated by broken lines are open in the sense that the flows they represent either move out of the circuit (savings) or enter into the circuit from outside. This dis­tinction is very important. We begin with the closed circuit.

Assume that firms make production decisions in the present based on the level of demand for their products. They may, for example, attempt to maintain a target or planned level of inventories of finished but unsold prod­ucts. As inventories are sold they must be renewed with current output. When demand is higher than current levels of output, inventories fall below planned levels. This indicates a need to increase levels of production. Given levels of demand, firms maintain levels of production appropriate to planned levels of inventories.

In order to maintain appropriate levels of production, firms must purchase required inputs of labor and materials. We can assume a more or less tech­nically determined relationship between these inputs and levels of output - that is, to produce a unit of output requires so many hours of labor and so many inputs of the various materials used to produce the specified product (see Chick, 1983:ch. 4; Pasinetti, 1977). We assume that while the amount of plant and equipment does not adapt to short-run fluctuations in demand, the existing plant and equipment can be operated at different levels of capacity utilization. Thus, the movements that concern us here are not movements of capital stock (fixed assets) but of output, demand, and working capital. Movements of capital investment in plant and equipment take us outside the “closed” part of the circular flow. In the short run, levels of capacity utili­zation adjust to variations in demand so that, to meet varying levels of de­mand, we need not carry out investment in plant and equipment.

The purchase of the productive inputs required to meet demand and main­tain inventories creates revenues for suppliers: for workers who supply labor and firms who supply materials. Workers and firms use the revenues they receive for two purposes, to acquire goods and to save. Saving usually means acquisition of a financial asset (for example, stocks and bonds), about which we shall have more to say below. The act of saving removes revenue (money) from the circular flow and, in itself, acts as a drain on that flow with the potential of disrupting the circuit and adversely affecting demand, thus caus­ing firms to reduce output and employment. We return to some of these implications of saving further on. For the moment, we focus on the spending decisions of individuals and firms.

The receipt of revenue by firms and workers induces spending, but for different reasons. Wages provide workers with their only or primary incomes. Because of this wages must be used to purchase needed means of consump­tion. The fact that workers depend in this way on employment and wages keeps the flow of value (money) going. Firms produce in order to make profit, and make profit in order to expand their capital and increase their productive capacity. Thus, while firms produce goods in order to make profit, they also make profit so that they can expand production. Since expansion of output (when sold) expands revenues, it induces investment in working capital and eventually in fixed capital (see Kalecki, 1978). Thus, the part of revenue spent by firms as a group generates demand for their products (ma­terials, means of consumption, and means of production). We have termed this “induced” demand since it results from current production decisions. It has the effect of absorbing inventories and thus stimulating another round of production decisions. The circuit begins once again.

To summarize, circularity results from the following three features of market economy:

1. A link exists between income and employment. Because a market is a system of property relations, acquisition of things agents need depends on the property they own: its type, its value, and its amount. Their wants and needs send individuals and firms into the market.

2. Incomes induce expenditures for individuals.

3. Demand induces both production and investment on the part of firms.

These three conditions depend primarily on the form of economic organi­zation. They do not result from psychological or technical conditions (al­though they involve such conditions). Outside of a private enterprise, private property system, individuals may still have wants and needs, and technical knowledge as embodied in means of production will still determine the extent and manner of need satisfaction. Yet, the peculiar circularity of a private enterprise market economy need not develop.