Building up the model In this next series of images we build up the circular flow model from just having a domestic sector and then adding in an external sector exports and imports before including the financial sector which channels savings and hopefully provides the finance available to fund investment. This leads to an equilibrium in the circular flow as the level of demand meets the level of supply in the economy. Banks are among the most familiar and important institutions found in financial markets. From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net exports, that is, X-M where X represents exports and M represents imports. If we illustrate these interactions, we can see that both money and goods and services move from one sector to the other in a circular motion. Economists call the wages plus the other forms of income, national income and give it the code ' Y'. The level of leakage or withdrawals is the sum of taxation T , imports M , and business savings S.
On the other hand Govt purchases final goods from the business sector, provides subsidies and makes transfer payments to firms in order to help them in production. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods. At the far left is the containing people seeking consumption. The inner loop represents the flows of inputs and outputs. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Injection An injection is any expenditure not originating in the household sector, including investment, government spending and exports. Without saving and investment, there would be a circular flow of income between business and the public: above, business pays out wages, interest, rents, and profits to the public in return for the services of labor and property; and below, the public pays consumption dollars to business in return for goods and services.
The business sector supplies products and demands resources used in the production process. Figure 1 Circular flow of income We can see this circular flow in Figure 1. It is thus clear from the above analysis that the flow of money income will continue at a constant level only when the condition of equality between planned saving and investment is satisfied. Therefore, planned savings must be equal to planned investment if the constant money income flow in an economy is to be obtained. If injections are higher than leakages, i.
We further assume that there are no inter-households borrowings. Export: Export is referring to as an injection into the circular flow that consists of payment receives for goods and services sold to the rest of the world. These add to the money flows which are shown in Fig. Another method of financing Government expenditure is borrowing from the financial market. There is a Trade Surplus for an economy when its exports exceed imports but the economy suffers Trade Deficit when imports exceed exports.
If value of exports exceeds the value of imports, trade surplus occurs. Two-sector economy is a hypothetical economy, whereas the three-sector economy is much more realistic. On the other hand, when the amount of leakage is greater than the amount injected into the circular flow, the national income will decrease. Assumptions The Basic Circular Flow of Income Model builds on three major assumptions. Money flows back to the government when it collects direct taxes income tax, wealth tax from the households. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services. According to him, since in a free market capitalist economy, investment is made by business enterprises and savings are mostly done by households and for different reasons, there is no guarantee that planned investment will be equal to planned savings and thus fluctuations in income, output and employment are inevitable.
These government expenditures are injections into the circular flow. Under these presumptions, the firm sector hires factor services from households who are owners of factors of production land, labour, capital and enterprise for producing goods and services and pays them remuneration or compensation in the form of money for rendering the productive services. Circular flow of income The circular flow of income is a way of representing the flows of money between the two main groups in society - producers firms and consumers households. If you do not know what these are then go to the data section of the course where there are worksheets and other materials on index numbers. Therefore, the spending goes back to firms.
At the far right is the that does the production. This circular flow of income also shows the three different ways that National Income is calculated. Let us first start with two sector model. It buys a portion of gross domestic product as government purchases. Besides the income and expenditure of the households and business firms, government purchases or expenditures and taxation also come into play. The other is indirect, via saving, financial markets, and investment.
Therefore, in case of trade deficit, domestic consumer households and business firms will borrow from abroad to finance their excess of imports over exports. Thus, savings of the firms going to the capital market and borrowing by the former from the latter also create money flows as shown in the following diagram. And then of course lastly you're gonna have your financial markets, and those will be your producers within that economic model. So, that gives you examples of consumers within that economic model. Money that is used to pay foreign entities for goods and services through M also constitutes a. Government borrowing increases the demand for credit which causes rate of interest to rise. Tax is leakages in income flow and it acts as a source of government revenue.
Government affects the economy in a number of ways. In this way, an equilibrium state exists in the economy where total demand equals total supply. These inputs are called the factors of production. Gross domestic product, the revenue received by the business sector, is the upper right-hand segment. They do so because, in addition to paying for the productive resources they need to carry out production at its current level, they desire to undertake investment. All types of taxes paid by the business sector also constitute leakage from the circular flow.
In addition to the household sector that spends C goods and the business sector that produces the goods, two sectors that are also included in the circular flow of income include the government sector and the foreign sector. When firms exports goods and services to the foreign markets, injections are made into the model. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. This circular flow of money is a measure of national income. Therefore income flows from firms to households. Government purchases do not transfer payments like social security, disability payments or unemployment compensation.