The circular flow model depicts the workings of the ordinary or real economy, the economy of production and consumption – the ordinary market of goods and services.
Savings and investment are auxiliary functions that impinge on this ordinary market. Savings and investment indicate the existence of an excess or overflow of money. This surplus pool of money gives rise to a second market, separated from the ordinary market of the real economy. This is the “financial market.” The gateway to this market is provided by banks and so-called non-bank financial intermediaries, who act as intermediaries, or trade on their own account, on the various submarkets comprising the financial market.
Since the 1980s, non-bank financial institutions have grown greatly in importance. Altogether they form the so-called “shadow banking system,” of which more later.
Another major actor on the financial market is the central bank.
We can see the functioning of this market in figure 3.
Here we see the actors on the other side of the fence. Banks and non-bank financial institutions form the go-between. On the other side are the stock markets, bond markets, and money markets. There is an additional actor here as well, the central bank, in the US known as the Federal Reserve System (Fed). The Fed operates on the financial market, not the ordinary market. It does so through so-called “open market operations,” buying and selling government debt (mainly Treasury bills). Recently the Fed has significantly altered practice by buying up mortgage-backed securities in equal amounts as government debt. This practice is known as “quantitative easing,” and we will discuss it in more detail further on.
The central bank also deals directly with the banking system. It establishes a required percentage of assets that banks need to deposit with it (reserve requirement). It also acts in emergencies to provide banks with various forms of assistance. After the credit crisis of 2008, it also established facilities to deal with non-bank financial intermediaries as well.
With regard to the two markets, one major point to realize is that they are separate from each other, and the “liquidity” in the one is not connected to the “liquidity” of the other. What happens in one market does not have any immediate impact on what happens in the other. The connection between the financial markets and the real economy is a tenuous one and depends on many factors. Contrary to popular belief, it is by no means a straightforward mechanical one. Thus, for instance, if the Fed “pumps” liquidity into the system, that liquidity does not touch the ordinary market, but stays in the financial market. In order for it to affect the ordinary market, it would have to be taken over by banks and used as a basis for increased lending, or, alternatively, be tapped into by corporations through the medium of the stock market, where rising values, driven up by increased liquidity, could serve to encourage fresh flotations.