The extended circular flow of the economy: the state, banks and the rest of the world

In “The simple circular flow of the economy”, you explored the basic model: households and businesses, connected by real flows and money flows. To make the basic pattern clear, we deliberately left everything else out – that is the trick behind every model. Now we will make the model more realistic step by step: first we bring the state back in, then we add banks, and finally the rest of the world.

Back to the bakery where you work during the holidays: each year, the bakery pays taxes on its profit – and your household pays taxes too, for example on its income. Households and businesses pay taxes to the state. But this money does not disappear: in return, the state provides public services that benefit everyone – the school you attend, the road outside the bakery, the police and the fire service.

Watch out for a common misconception: taxes are not a service that the state provides to households – they flow in exactly the opposite direction. Taxes are a money flow to the state; public services flow back from the state.

The state also has two other roles, which you know from “Economic activity: households, businesses and the state”: it is an employer – teachers, police officers and local council staff receive their wages from the state. And it is a buyer: when the country has a road built, it hires and pays businesses to do the work.

So far, everyone in the circular flow has spent their money again straight away. In reality, you put some of your holiday job wages into a bank account – you save. The bakery also puts some money aside in good months. This money is held at the bank as a deposit.

If these savings simply stayed in a vault, they would be lost to the circular flow. This is where banks come in: they collect deposits from many savers – and pass the money on as loans to those who currently need more than they have. If the bakery wants to buy a new oven but cannot pay for it all at once, the bank lends it the money.

The bank is therefore an intermediary: saving flows in on one side, and loans flow out on the other – saving and investment are linked. Some of the money you saved from your holiday job might therefore indirectly help to pay for your bakery's new oven.

You will look more closely at how the bank itself makes money and exactly what a loan costs (the key term is interest) later in “Banks: their roles, loans and interest” – here, we are only concerned with the flows.

No country's economy operates in isolation. The flour for your bakery might come from a mill in Switzerland – an import: goods flow in from abroad, and money flows out. Conversely, businesses in Liechtenstein sell their products all over the world – for example, a machinery manufacturer supplies equipment to Zürich: an export. Goods flow out, and money flows in.

The rest of the world is important to Liechtenstein for another reason too: workers. Most people employed in Liechtenstein do not actually live in the country. Instead, they travel in from Switzerland and Austria every day as cross-border commuters – from Buchs, Sevelen or Feldkirch to work in Vaduz, Schaan or Eschen. In the circular flow, this means that their labour flows into Liechtenstein (a real flow), while their wages flow out to other countries (a money flow) – where they are spent or saved.

Liechtenstein and Switzerland thus form a closely connected economic area: goods, workers and money cross the border along the Rhein in both directions every day – and payments on both sides are made in Swiss francs.

Look at the diagram again: two participants have become five, and four flows have become many more. With each extension, the model has become more realistic – the circular flow with the state, banks and the rest of the world already describes everyday life in Liechtenstein quite well.

Even so, the extended circular flow is still a model – a deliberate simplification of reality. Many things are still missing: insurance, clubs and associations, inheritances, undeclared work, the environment and raw materials. And for each new participant, we have only drawn the two most important flows – in reality, there are many more connections.

This is deliberate, not a flaw: a model should not show everything, but make the important things clear. If we drew every single flow, the diagram would be an unreadable tangle. The skill lies in leaving out just enough to keep the pattern clear – and adding just as much as the question requires. If you want to understand why the bakery gets a loan, you need banks in the picture; if you only want to understand the exchange of 'work for wages', the basic model in “The simple circular flow of the economy” is enough.