Inequality in Personal Finance

Understanding the circular flow of income

NARRATOR:
We'll start with a very simple economy. Assume for now that the economy is composed of just two
sectors households and firms.
Households consume the goods and services produced by firms. They do this by spending the
income, the wages they get from supplying the labour to the firms.
In this simple economy the value of all the goods and services produced by firms can be thought
of as the entire national income of that economy, called its Gross Domestic Product or GDP.
Since the entire income received by households is spent buying all those goods and services the
income of households is another way of measuring GDP.
So far we have assumed that households spend all their income but in reality some households will
spend less, this may be because they receive more income than they need for present
consumption. Or they realise they need to reduce their current consumption so they can consume
more later on. In either case they will save some of their income. Typically they will deposit the
money they save into bank and savings accounts pension schemes and so on. We can call all
these banks and other institutions that accept their savings the Financial Sector. Households
receive interest or other incomes such as dividends from the Financial Sector.
The Financial Sector will lend to or buy shares in firms.
This injection of money will enable firms to invest in better technology and to innovate so that they
grow and produce even more goods and services which can then be consumed by Households
which may also share in the growth through rising wages. Firms that are making a profit will use
some of it to provide a return on the loans and shares held by Households via the Financial Sector.
As you can see this saving process by Households transforms income into assets, shares or
deposits which in turn generates additional income. This flow of money from savings by
Households to investments buy firms is the essence of a capitalist system. It is an important
source of economic growth that is an expansion of countries' GDP. The question is: how this

growth, this increase in national income, is re-distributed. We have seen that there are two main
possibilities wages might increase in which case working households share in the increasing
national income.
Savers may receive a return on the deposits and share they hold via the Financial Sector.
In our simple model, the extent to which different households benefit from a rise in GDP will
depend on whether the wages rise or whether they have any savings. The extent to which rising
GDP is passed onto wage earners is complex and depends on factors such as the power of unions
to negotiate wage increases and the ability of workers to increase their productivity and earning
power, for example, by acquiring new skills, or working more efficiently with the aid of better
machines.
Higher income households have greater saving capacity than lower income households and are
therefore more likely to benefit from rising GDP. If the return on saving grows faster than the return
from labour that is the wages, then those who can save and accumulate financial assets will get
richer more quickly than those who depend on their labour to earn income. It is this difference in
the two rates of growth that creates a trend of growing inequalities. And the larger this difference
the greater the incentive becomes for people to seek to increase their income and wealth by buying
financial assets without necessarily aiming at increasing the productive capacity of the country.
Influential economist Thomas Piketty explains this phenomenon for different advanced economies
by showing long-term inequality trends over one hundred years.
One way in which countries deal with inequalities is to operate some form of redistribution between
the different sectors of the economy and therefore also between households. This mostly happens
through government intervention. Part of the income from employment and profits from business
activities is collected by government in the form of taxes which can then be redistributed in
different forms according to different priorities.
Government spending goes to households and in some cases firms in the form of public services
such as education, healthcare, social care, social housing or public safety, social protection in the
form of cash transfers to pay for pensions, cost of children or to top up incomes of the poorest.
And subsidies to companies in some strategic sectors such as private childcare services, green
energy companies or research and development.
This redistributive mechanism reduces inequality in several ways. First provided the tax system is

progressive the rich pay proportionately more than the poor. A progressive tax system is one
where the average tax rate paid by richer households is higher than the average tax rate paid by
poorer households. Second low income households are more likely to be users of public services
because they are less likely to be able to afford the alternatives. Third, some transfers are meanstested meaning that they are only available to households with low income and assets. And finally
some revenue funds the public system of education and care to varying degrees between countries
which gives more equal chances to children of the following generation.