In particular, financial markets provide a means of generating the revenue that the business sector uses to pay for investment expenditures. Short-run changes in investment expenditures can cause business-cycle instability. The flow of funds through financial markets also affects the purchase of capital goods, which then affects production capabilities and long-run economic growth.

Legal Claims

The exchange of legal claims also occurs with the lending and borrowing that consumers, business, and banks do through the banking system. Insurance is another legal claim, a claim on an uncertain future, that is also traded through financial markets. Foreign exchange markets trade the currency of different nations, which is essential to foreign trade.

Legal claims provide the mechanism for accumulating the funds used for capital investment. In fact, without legal claims and financial markets the economy would find it nearly impossible to invest in large scale capital projects.

Buyers and Sellers

However, the household sector is generally a net buyer of legal claims and thus a net saver, while the business and government sectors are usually net sellers and borrowers. In other words, the household sector diverts a portion of income to the financial markets which is then used by the business and government sectors to finance their spending.

• Household Saving: The household sector both buys and sells legal claims through the financial markets. When it buys legal claims, it diverts income to the financial markets, which is saving. When it sells legal claims, it obtains funds from the financial markets, which is borrowing.

  By virtue of its ownership of all factors of production, the household sector lays claim to all income generated from the production of goods and services. A portion of this income is necessarily used to finance investment expenditures and government purchases through saving. As such, the household sector is necessarily a net buyer of legal claims. The legal claims commonly purchased in the course of saving are bank accounts, corporate stocks, and government securities.



• Business Borrowing: The business sector also both buys and sells legal claims through the financial markets. While it often buys legal claims with extra revenue not immediately claimed by the factors of production, it is primarily a seller. The business sector sells legal claims to finance investment expenditures for capital goods.

  In that the business sector has no ownership of productive factors, it has no direct claim on income. It must ultimately obtain any income used for investment expenditures from the household sector. It does this by selling legal claims such as corporate stock, corporate bonds, and bank promissory notes (loans).



• Government Borrowing: Legal claims are also both bought and sold by the government sector. Like the business sector, the government sector frequently buys legal claims with extra tax revenue not immediately needed for expenditures. However, it is also a major seller of legal claims.

  In that the government sector, like the business sector, also has no ownership of productive factors, it must obtain the income used for government purchases from the household sector. The majority of this income is acquired through taxes. However, when the tax revenue needed to finance expenditures comes up short, it sells legal claims through the financial markets. A couple of the more popular legal claims used to obtain this extra revenue are government securities and municipal bonds.

One of Three

• Product Markets: The production of final goods and services, what is formally termed gross domestic product, is exchanged through product markets. The buyers of this production are the four macroeconomic sectors--household, business, government, and foreign. The seller of this production is primarily the business sector. A substantial part of macroeconomics is devoted to explaining how and why gross domestic product exchanged through the product markets rises or falls.




• Resource Markets: The services of the four factors of production--labor, capital, land, and entrepreneurship--are traded through resource markets. Resource markets, also termed factor markets, are used by the business sector to acquire the factor services needed for production. Payment for these factor services then generate income received by the household sector, which owns the resources. Note that only factor services are exchanged through resource markets, not the actual factors.

The Circular Flow

The Circular Flow

The four main components of this simple model are: household sector, business sector, product markets, and resource markets. The household sector contains the consuming population of the economy. The business sector includes all of the producers.

The product markets direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction. The resource markets direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction.

The financial markets enter the circular flow as a means of temporarily diverting household saving away from the product markets. This diverted income is acquired by the business sector to finance investment expenditures and the government sector to finance government purchases.

Aggregate Equilibrium

Equilibrium in the aggregate financial market is an essential aspect of macroeconomic analysis. In particular, overall macroeconomic equilibrium, both short-run equilibrium and long-run equilibrium, requires aggregate financial market equilibrium. This exists if the total quantity of legal claims supplied is equal to the total quantity demanded. In other words, saving equals borrowing.