Here is a circular flow of income that I took from Krugman's macroenomics textbook. Please notice, in this diagram households just give their savings to banks (which are part of the financial sector) and everybody else seem to just take these money, not returning them. For an example, Government transfers to households are just good old welfare, not payment for money that the government borrowed from households. Besides, the financial market gives access not only to savings of national households, but also to savings of foreign households. So there should be a separate outward flow from the Government and Firms specifically to the finanical market and specifically for paying their debts. As for the Foreign sector, it needs to add "payment for debts" to its out outward flow to the financial market. But even without the Foreign sector normally debts are paid to banks, rather than directly to people who keep their money in banks.

Do I read the diagram wrong? If yes, how do then Government, Firms and the Foreign sector return money that they borrowed from households according to this diagram? If no, then why does this scheme NOT include any flows for returning borrowed money? I understand that it's all simplification of real life, but presenting borrowing in way that is indistinguishable from charity seems like an OVERsimplification, I don't see reasons why to present borrowing like this. Please enlighten me if you understand why borrowing was presented like this, like a charity.

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For the households it would through the savings arrow. Borrowing from macroeconomic perspective can be and in most advanced textbooks (such as Romers advanced macroeconomics) is often treated as a negative saving.

Hence when the households and businesses borrow they incur negative saving and when they repay debts it can be viewed as a positive increase in saving (which for people who borrowed would be negative).

This can actually be clearly seen from the diagram since savings arrow goes to the financial market and from financial market you get the borrowing.

It’s not that the financial markets lend people money - people lend money to each other through financial markets and then pay it back from the savings.

Saving is the difference between your income and consumption so in order to pay any debt you have to save (if you consume all your income you cannot pay your debts).

When it comes to the government it technically pays back by public savings which occurs when taxes are larger than spending so there in principle you could argue there should be another savings arrow from the government. However, I think that Krugman decided to include this in the transfer arrow. If you buy a government bond and your government is paying you back interest you could consider it as transfer.

  • $\begingroup$ Okay, so the government pays to its national creditors directly. But how about FOREIGN creditors whose savings the government borrowed from the financial market? $\endgroup$ – user161005 May 12 '20 at 3:13
  • $\begingroup$ Also you mentioned that when firms return money it can be viewed as negative savings. But wait a minute, as far as I know national savings consist only of private savings and public savings, where private savings are savings of households. There is no place for savings of businesses in the formula of national savings. So how can we even say that savings of businesses are a thing?? $\endgroup$ – user161005 May 12 '20 at 3:28
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    $\begingroup$ @user161005 indeed paying international creditors would not be covered by transfers to households, as I mentioned it can be argued there should be an arrow from the gov to fin sector. When it comes to firms they belong to households, this is why you can see profit and interest not just wages coming from the firms through factor markets to them. As with financial markets it’s not like firms are some extra entities. Some households set up firms others decide to work for them, if firms borrow you can say they owners pay back directly - its a model it’s supposed to be simplified version reality. $\endgroup$ – 1muflon1 May 12 '20 at 10:14

In fact, the picture is an OVERsimplification, but not only. Payback of debt could be considered in the same arrow of borrowing, just in opposite direction and, in fact, taking the arrow the net flow, after subtracting amortization from new gross borrowing we'd have both included... But there remains unnoticed the remuneration of those financial investments. In fact, in "factor markets" there are included "interests", which are the remunerations that we are missing.

So, for sticking to the question and refrain to follow the thread further: the answer is that you read the picture very well, and that it's the picture which contains OVER simplifications and plain failures.

It's the striking (though very common) lack of rigor of introductory economics textbooks. But don't miss it: those seemingly inaccuracies don't steam from lazyness, but very deep questions which have no answer in conventional economics.


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