All such expenditures by the government are injections into the circular flow. Figure 2 Circular flow - savings and imports S and M are called leakages from the circular flow. In this way as a result of net capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets. So there is a circular flow of income in between two sectors — household sector and firm sector. Example According to the diagram above, there are two opposing flows between the households and the firms. On the other hand, imports are leakages from the circular flow.
Government does not play any part in the national economy. Similarly, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking, etc. The goods and services are produced by the firms to be consumed by the households. The state of equilibrium in the two-sector economy is defined as a situation in which no change occurs in the levels of income Y , expenditure E , and output O. Real flow indicates the factor services flow from household sector to the business sector, and goods and services flow from business sector to the household.
To finance the deficit budget, the Government will borrow from the financial market. Circular Income Flow in a Three Sector Economy with Government : In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. One person's expenditure is another's income. Even though this partly goes to pay themselves and their bureaucracy, as well as funding schools and hospitals, it finds its way back into the flow. The money to buy these goods and services flows out of the country. Circular Flow of Income in a Four-Sector Economy: Two-sector economy and three-sector economy are briefly discussed in previous sections. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.
On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. We called the economy illustrated in Figure 3 an open economy because it is open to trade with the outside world. If exports are equal to the imports, then there exists a balance of trade. In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular flow of income. Since the household sector spends the whole income on the purchase of goods and services, therefore, there are no savings and investments.
Thus, the identity iii shows that the value of output produced or sold is equal to the total income received. Thus total sales again equal production of firms. In goods and services markets, households buy finished products from firms that are looking to what they make. We can prove their identity in the following way. The continuous flow of money between these sectors and markets guaranteed the exchange of products and services between consumers and producers, thereby enabling both sectors to pay their taxes to the government. Firms spend on investment in order to expand their productive capacity in future.
Thus Government borrowing reduces private investment in the economy. Paid to the government in taxation T e. Figure 1 Circular flow of income We can see this circular flow in Figure 1. These activities are represented by the blue lines in the diagram above. During depression, this volume of flow of money will contract and less and in prosperity it will expand with changes in national income.
The circular flow of income or circular flow is a of the in which the major exchanges are represented as flows of , and , etc. Rising income, output and employment levels will lead to an expansion, the economy is in a boom. The ignores the linear throughput of matter and energy that must power the continuous motion of money, goods and services, and factors of production. Payments Foreign sectors need to make payment to the business sector from where imports have been made. The credit market itself is controlled by the government through monetary policy. Put aside for future spending, i. Importance of Trade Policies: Similarly, imports are leakages in the circular flow of money because they are payments made to a foreign country.
Here flows from household sector and producing sector to government sector are in the form of taxes. All types of taxes paid by the business sector to the government are leakages from the circular flow. Money flow of savings is shown from the households towards the financial market. Hansen, Lloyd A Metzler; New York, W. Leakages reduce the flow of income. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool the farmer therefore more money enters the economy thus making it an injection. The money flow from households and business firms to the government is labelled as tax payments in Fig.
Payments The income of the household sector flows into the business sector, government sector and capital markets in the form of consumption expenditure, taxes and savings respectively. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Rate of interest, which is the price for the use of savings, is determined by saving and investment. When households and firms borrow the savings, they constitute injections. Of course, in our above analysis of circular flow of income, we explained that planned investment by business firms can differ from savings by household. On the other hand, if injections into the circular flow exceed leakages, the income is increased in the economy.