The following points highlight the eight main advantages of the circular flow of money in an economy. The advantages are: 1. Link between Producers and Consumers 2. Creates a Network of Markets 3. Inflationary and Deflationary Tendencies 4. Basis of the Multiplier 5. Importance of Monetary Policy 6. Importance of Fiscal Policy 7. Importance of Trade Policies 8. Basis of Flow of Funds Accounts.
Advantage # 1. Link between Producers and Consumers:
The circular flow of money establishes a link between producers and consumers. It is through money that producers buy the services of the factors of production with which the latter, in turn, purchase goods from the producers.
Advantage # 2. Creates a Network of Markets:
As a corollary to the above point, the linking of producers and consumers through the circular flow of money has created a network of markets for different goods and services where problems relating to their sale and purchase are automatically solved.
Advantage # 3. Inflationary and Deflationary Tendencies:
Leakages or injections in the circular flow of money disturb the smooth functioning of the economy. For example, saving is a leakage out of the expenditure stream. If saving increases, this depresses the circular flow of money. Given the supply of money in the economy, this tends to reduce employment, income and prices, thereby leading to a deflationary process in the economy.
On the other hand, consumption expenditure and investment are injections in the circular flow of money which tend to increase employment, income, output and prices, and thus lead to inflationary tendencies.
Advantage # 4. Basis of the Multiplier:
Again, if leakages exceed injections in the circular flow of money, the total money supply becomes less than the total output. This leads to a cumulative decline in employment, income, output, and prices over time.
On the other hand, if injections into the circular flow of money exceed leakages, the money supply is increased in the economy. This leads to a cumulative rise in employment, income, output, and prices over a period of time. In fact, the basis of the Keynesian multiplier is the cumulative movements I the circular flow of money.
Advantage # 5. Importance of Monetary Policy:
The study of the circular flow of money also highlights the importance of monetary policy in bringing about the equality of saving and investment. The equality between saving and investment comes about through the capital market. The capital market is controlled by the government through its monetary policy.
When saving exceeds investment or investment exceeds saving, there is deflation or inflation. It is through monetary policy that investment is encouraged or retarded to control deflationary or inflationary situations.
Advantage # 6. Importance of Fiscal Policy:
The circular flow of money also points towards the importance of fiscal policy. For the circular flow of money to be in equilibrium, saving plus taxes (S+T) must equal investment plus government expenditure (I+G) . S+T represent leakages from the money stream which must be offset by injections of I+G into the money stream.
So if S+T exceed I+G deflationary tendencies develop in the economy which can be removed by adopting such fiscal measures as reduction in takes and by increase in government expenditure. On the other hand, If I + G exceed S + T there are inflationary tendencies in the economy which can be checked by encouraging saving and increasing government, revenues through taxation. Thus the circular flow of money highlights the importance of adopting compensatory fiscal policy.
Advantage # 7. Importance of Trade Policies:
Similarly, imports are leakages in the circular flow of money because they are payments made to a foreign country. To stop it, the government adopts such measures as to increase exports and decrease imports. Thus the circular flow of money points towards the importance of adopting export promotion and import control policies.
Advantage # 8. Basis of Flow of Funds Accounts:
The circular flow of money helps in calculating national income on the basis of the flow of funds accounts. The flow of funds accounts are concerned with all transactions in the economy that are accomplished by money transfers.
They show the financial transactions among different sectors of the economy, and the link between saving and investment, and lending and borrowing by them. To conclude, the circular flow of money possesses much theoretical and practical significance in an economy.