Countries such as America and the UK have a consumer/credit based economy. The ‘circular flow’ simply means businesses hire people to produce goods and services. The people then use their earnings, sometimes with the help of loans, to purchase those goods and services. The more goods and services purchased the more jobs it creates, and higher wages. And so the cycle continues.
When the economy goes into recession, usually the result in an artificially created market, like house prices going up, creating a bubble that bursts and people lose money, the amount of money circulating in the economy declines. Some people save, rather than spend and many lose their jobs because of decreased demand for goods and services when people stop spending. Homes go into foreclosure, people and business default on loans, the money supply becomes tight, and credit virtually ceases. That creates a reverse cycle, where people and investors have even less to spend or invest, business sales decline, and more people lose their jobs.
That can begin a ‘deflationary’ economy that spirals out of control. Prices drop as more and more people stop buying or cannot afford to. People hold on to their money, stop investing and the economy shrinks until it hits bottom which would be the result of a purely market drive economy.
Before that happens, In America the government generally reacts with ‘quantitative easement’ The Federal Reserve prints more money. The US Treasury prints treasury securities that the Fed buys with the printed money. The government then ‘spends’ or loans the new money to create a greater supply of currency available for credit and spending. It's sort of like saving a dying patient by putting them on life support. Once the economy begins to recover, the government buys back the securities from the Fed which takes the liquidity (extra printed money) out of the economy and so prevents inflation from setting in.
When the economy goes into recession, usually the result in an artificially created market, like house prices going up, creating a bubble that bursts and people lose money, the amount of money circulating in the economy declines. Some people save, rather than spend and many lose their jobs because of decreased demand for goods and services when people stop spending. Homes go into foreclosure, people and business default on loans, the money supply becomes tight, and credit virtually ceases. That creates a reverse cycle, where people and investors have even less to spend or invest, business sales decline, and more people lose their jobs.
That can begin a ‘deflationary’ economy that spirals out of control. Prices drop as more and more people stop buying or cannot afford to. People hold on to their money, stop investing and the economy shrinks until it hits bottom which would be the result of a purely market drive economy.
Before that happens, In America the government generally reacts with ‘quantitative easement’ The Federal Reserve prints more money. The US Treasury prints treasury securities that the Fed buys with the printed money. The government then ‘spends’ or loans the new money to create a greater supply of currency available for credit and spending. It's sort of like saving a dying patient by putting them on life support. Once the economy begins to recover, the government buys back the securities from the Fed which takes the liquidity (extra printed money) out of the economy and so prevents inflation from setting in.
