So far in our discussion of the circular flow theory, financial intermediaries have been left out of the picture, literally. The financial sector, or intermediaries like banks, credit unions, insurance companies, and stock exchanges, help to facilitate all of the transactions that have been mentioned in this discussion. The importance of financial intermediaries cannot be underestimated. They stand in the middle of almost all transactions. Without them, most modern markets would be unable to function. They are the grease that makes the wheels turn smoothly, the key that unlocks the door, the wind beneath your wings.
Most of the transactions that are conducted in the product market either involve the use of checks, debit cards, credit cards, cash drawn from ATMs (rather than from under your mattress), or in the case of exports and imports, foreign exchange. All of these services are provided by the financial intermediaries but of course not out of the goodness of their hearts. Rather, like any business, they are motivated by the potential of profit, so they charge a fee for their services.
The financial sector is all about making it easy for people to spend money. If you have an app that lets you wave your phone at a cash register in order to pay for that cup of coffee, you know exactly what I’m talking about. The financial sector is everywhere:
It’s fairly obvious how financial intermediaries such as banks are involved in product markets—just a little observation of your own habits will demonstrate. It’s kind of hard to give Amazon.com that $20 bill in your wallet, but it’s a piece of cake to give them your credit card number. However, financial intermediaries are equally involved in the factor market. This is not because they use land and labor (although they do). It is because they are involved in many, if not most, transactions on the factor market. Most working Americans receive a paycheck, not cash. The paycheck gets deposited in a bank or credit union, not in a jar buried out in the backyard. Buying and selling land (a factor) almost always involves financial intermediaries. Capital itself is a factor of production. Where do people find capital? Yup. In the financial sector.
The financial sector generates a significant amount of revenue in the form of interest payments for mortgages and loans. That fact is connected to a dimension of the circular flow theory that we haven’t discussed yet—the part of the economy that involves savings, not spending.
Up to this point, all of the income that has been earned by households, firms, government, and the rest of the world has been spent in the circular flow model. Dollar in = dollar out. But private, public, and foreign sectors don’t only spend money—they also save it. To account for the fact that the different economic sectors save a portion of their income, the circular flow model enters the third dimension.
This third dimension is the financial markets. Households save for the future, government can run a budget surplus, businesses retain earnings for future investment, and the foreign sector engages in real and portfolio investment in the United States. Where do all of these savings go? Savings flow to financial intermediaries and from there (in the form of loans) to all sectors of the economy: