Sources of Funds in an Economy (Money, Credit, Income)

The dynamics of an economy are driven by various factors, with the sources of funds – money, credit, and income – being important to understand.

It’s these things that end up moving the prices of everything and flows between spending, investing, and saving in an economy.

Inflation is characterized by a general rise in price levels and can be influenced by the growth rate of income relative to an economy’s output capacity.

On the other hand, money, credit, and income serve as the primary sources of funds, each contributing to economic activity and growth in unique ways (i.e., consumption, investing, and saving).

Money primarily flows into financial markets.

Credit often goes towards spending on goods and services or investments in non-financial assets.

Income, the earnings individuals and businesses receive for their labor, investments, and other productive activities, can also significantly impact consumer spending and inflation.

We look at their roles and impacts on the overall economy.

Key Takeaways – Sources of Funds in an Economy: Money, Credit, Income

• The dynamics of an economy are influenced by money, credit, and income as key sources of funds, each playing a unique role in economic activity and growth.
• Inflation, characterized by a general rise in price levels, can be influenced by income growth relative to an economy’s output capacity and can impact the overall economy.
• Understanding the relationship between money, credit, and income, as well as their relationship with factors like nominal spending and monetary policy, is essential for analyzing and shaping economic conditions effectively.

Understanding the Background: Inflation

Inflation is an economic phenomenon characterized by a general rise in price levels in goods and services.

Income Growth vs. Output Capacity

When incomes grow at a rate faster than an economy’s ability to produce output, inflation is usually going to be the result (though it depends on the amount spent relative to the amount that gets saved and what goes into financial assets).

A discrepancy between income growth and output capacity can lead to increased spending power for individuals, potentially leading to “demand-pull” inflation.

Nominal Spending Growth vs. Bond Yields

Another important factor influencing inflation is the level of nominal spending relative to bond yields.

When bond yields are low, debt service payments become easier to manage, making it simpler for individuals and businesses to obtain and sustain credit.

This accessibility to credit, in turn, can stimulate economic activity and lead to higher prices.

Source of Funds: Money

Money, as a source of funds, primarily flows into markets and is critical in facilitating economic activities.

A tightening of monetary policy – such as raising interest rates or reducing the supply of money – often has the most immediate effect on money rather than on credit.

When the Federal Reserve, or any central bank, prints money, it does so with the intention to purchase bonds or other financial assets.

The central bank’s role is not to directly buy goods and services – like the fiscal government might – directly (by buying them itself) or indirectly (by handing money out to others who then buy goods and services).

Rather, the central bank’s job is to influence monetary policy and maintain economic stability.

Source of Funds: Credit

Unlike money, most credit in an economy goes towards spending on goods and services or investments in non-financial assets.

When a person takes out a loan, for example, they are likely to use this credit to buy tangible assets like a car or a house.

This is distinct from the usage of newly printed money, which, as previously mentioned, is often directed toward purchasing financial assets.

Credit expansion, often facilitated by lowering interest rates or relaxing lending standards, often supports spending in an economy.

Thus, any pullback in liquidity, or the availability of funds, can negatively impact financial markets.

Credit creates debt, which produces an obligation to deliver money in the future.

For example, a bond is simply a promise to deliver currency over time.

Source of Funds: Income

Income is another significant source of funds within an economy.

Income refers to the earnings individuals and businesses receive for their labor, investments, and other productive activities.

When incomes rise faster than output, it can result in an increase in consumer spending and potentially lead to inflation, as previously discussed.

However, a steady increase in income that aligns with productivity growth is generally seen as a sign of a healthy and growing economy.

Most of our big-picture economic problems are caused by debt growth that’s in excess of income growth that’s in excess of productivity growth.

FAQs – Sources of Funds in an Economy: Money, Credit, Income

What are the main sources of funds in an economy?

The main sources of funds in an economy are money, credit, and income.

• Money is the most liquid asset and serves as a medium of exchange, a unit of account, and a store of value. It can be used immediately to purchase goods and services.
• Credit is created when financial institutions extend loans to individuals and businesses. This credit can be used to make purchases, fund business operations, or invest.
• Income is the earning from labor, capital, and entrepreneurship activities. It includes wages, interest, rents, and profits.

These sources of funds drive economic activities, including consumption, investment, and the payment of taxes.

How does inflation impact the sources of funds in an economy?

Inflation impacts the sources of funds in different ways.

If incomes grow faster than an economy’s ability to produce output, this can lead to inflation.

Higher income means consumers have more money to spend, which can drive up prices if demand exceeds supply.

Inflation can also affect the real value of money and credit.

When inflation is high, the real value of money decreases as each unit of currency can purchase less than before.

This can erode savings and decrease purchasing power.

Similarly, the real burden of debt can decrease in an inflationary environment, making it easier to repay loans with “cheaper” money.

This is also why investors want a “real” return on their investment – i.e., a positive inflation-adjusted return.

Though many simply look at their investments in nominal terms, it’s real returns that matter.

What is the relation between nominal spending, bond yields, and sources of funds?

Nominal spending is the total amount of money spent by households, businesses, and the government in an economy, without adjusting for inflation.

Bond yields are the return an investor receives on a bond.

When the level of nominal spending is high relative to bond yields, it implies that money is cheap, and it’s easy to make debt service payments.

This can lead to an increase in credit in the economy, as it’s easier for individuals and businesses to borrow and sustain that debt.

This also implies an increase in spending, which could potentially lead to inflation.

How does a tightening of monetary policy affect the sources of funds?

A tightening of monetary policy typically means the central bank (such as the Federal Reserve in the US) is raising interest rates or reducing the money supply.

This has the most immediate effect on money, not credit.

As money becomes more expensive, it becomes less attractive for investors to put it into riskier assets as risk premiums compress, which could lead to a pullback in liquidity and exert a drag on financial markets.

How does the Fed’s printing of money affect the economy?

When the Federal Reserve, or any other central bank, prints money, it typically does so to buy bonds or other financial assets in a process called open market operations.

This increases the amount of money in the financial system, reduces interest rates, and encourages lending and investment.

However, note that this money is not used to buy goods and services directly.

Its primary purpose is to stimulate economic activity indirectly by reducing the cost of borrowing and encouraging spending.

How does taking out a loan affect the economy?

When a person or a business takes out a loan, they’re most likely going to use that credit to buy goods or services, such as a car or house, or to invest in business operations.

This activity stimulates economic growth because it increases spending.

Unlike the Fed’s printing of money, the expansion of credit through loans directly supports spending, which can help sustain or boost economic activity.

What are the effects of changes in liquidity and credit expansion on financial markets and spending?

A pullback in liquidity, often due to a tightening of monetary policy or financial instability, can act as a drag on financial markets.

It can reduce the money available for investment and push up interest rates, which can deter borrowing and investing.

On the other hand, the expansion of credit through the issuance of new loans or a decrease in interest rates can support spending.

More credit means more funds available for consumers and businesses to spend or invest.

This can lead to increased economic activity and growth.

However, if not managed carefully, an excessive expansion of credit can also lead to inflation or financial bubbles.

Conclusion

The sources of funds – money, credit, and income – is integral to comprehending the dynamics of an economy.

Each of these elements plays a role in shaping different types of economic activity – spending on goods and services, investments in financial assets, and savings.

Inflation, influenced by income growth and output capacity, can significantly impact the economy’s health.

Money, as a source of funds, primarily facilitates economic activities, while credit often supports spending and investment.

Income, on the other hand, can influence consumer spending and potentially lead to inflation.

The relationship between these elements, coupled with factors such as nominal spending, bond yields, and monetary policy, works to influence the combination of spending, investing, and saving levels in an economy.

An understanding of these factors is crucial for effective economic analysis and policymaking.