So far, we have told this story in terms of individual markets. The circular flow helps us see how these markets come together in the aggregate economy. When we looked at the markets for housing and beef, we saw that a decrease in demand for housing led to a decrease in demand for labor and, hence, to lower labor income. We also saw that as income earned in the housing market decreased, spending decreased in the beef market. Such linkages are at the heart of the circular flow of income. Household spending on goods and services is made possible by a flow of income from firms. Firms’ hiring of labor is made possible by a flow of revenue from households. Keynes argued that this was a delicate process that might be prone to malfunction in a variety of ways.
Households are willing to buy goods and services if they have a reasonable expectation that they can earn income by selling labor. During the Great Depression, however, household expectations were surely quite pessimistic. Individuals without jobs believed that their chances of finding new employment were low. Those lucky enough to be employed knew that they might soon be out of work. Thus households believed it was possible, even likely, that they would receive low levels of income in the future. In response, they cut back their spending.
Meanwhile, the willingness of firms to hire labor depends on their expectation that they can sell the goods they manufacture. When firms anticipate a low level of demand for their products, they do not want to produce much, so they do not need many workers. Current employees are laid off, and there are few new hires.
Through the circular flow, the pessimism of households and the pessimism of firms interact. Firms do not hire workers, so household income is low, and households are right not to spend much. Households do not spend, so demand for goods and services is low, and firms are right not to hire many workers. The pessimistic beliefs of firms and workers become self-fulfilling prophecies.
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