On the other hand, imports are leakages from the circular flow. The income earned daily flows back to businesses continuously in a cycle known as the circular flow of income. 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. By net capital inflow we mean foreigners will borrow from domestic savers to finance their purchases of domestic exports. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as well as payment of subsidies and transfer payments.
As the income falls households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. The capital market coordinates the saving and investment activities of the households and the business firms. Basis of Flow of Funds Accounts: The circular flow helps in calculating national income on the basis of the flow of funds accounts. Exports are an injection or inflows into the economy. Expenditure has now two alternative paths from household and product markets: i Directly via consumption expenditure, and ii indirectly via investment expenditure. Circular money flow with saving and investment is illustrated in Fig.
If total injections exceed total leakages more money is being added than removed, therefore income and expenditure will rise leading to a demand for goods and services leading to higher rates of unemployment meaning unemployment will fall. The money flow from households and business firms to the government is labelled as tax payments in Fig. They may be in form of savings, tax payments, and. Circular Flow of Income The amount of income generated in a given economy within a period of time national income can be viewed from three perspectives. 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. The circular flow has another leakage in the form of Taxation T from households and an injection of Government Expenditure G into firms.
Then flow of investment expenditure is shown as borrowing by business firms from the financial market. On the other hand, some firms make and sell exports overseas, and others borrow money and invest it in their firms in the form of capital goods. Finally, the government creates flows both to the households and the businesses, offering services and receiving funds. The natural materials that power the motion of the circular flow of the economy come from the environment, and the waste must be absorbed by the larger ecosystem in which the economy exists. These government expenditures are injections into the circular flow. As already noted, taxation is a leakage from the circular flow. For the circular flow of income to continue unabated, the withdrawal of money from the income stream by way of saving must equal injection of money by way of investment expenditure.
On the other hand, the business sector makes payments to the foreign sector for imports of capital goods, machinery, raw materials, consumer goods, and services from abroad. These exports and imports in the circular flow are shown in Figure 4. The government borrowing through its effect on the rate of interest affects the behaviour of firms and households. Here we will concentrate on its taxing, spending and borrowing roles. If exports exceed imports, the economy has a surplus balance of payment.
Figure 3 Circular flow - two sector, open economy This is a 2-sector, open economy. On the other hand, if net taxes exceed government purchases the government will have a budget surplus. The level of economic activity in an economy will determine the levels of income, output and expenditure for that economy as a whole. Since the first assumption is relaxed there are three more sectors introduced. The government is the firms, as all firms are owned by the government state. If the leakages are greater than the injections then national income will fall, while if injections are greater than leakages national income will rise. If injections are higher than leakages, i.
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. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. Goods flow from the business sector to the household sector in the product market, and services flow from the household sector to the business sector in the factor market, as shown in the inner portion of the figure. A result, circular flow of money speeding and income remains undiminished. These materials and energy are used by households and firms a like to create products and wealth. If saving increases, this depresses the circular flow of income. If markets for goods and services were the only markets available, firms would eventually have all of the money in an economy, households would have all of the finished products, and economic activity would stop.
Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction. Money Income Flows in the Four Sector Open Economy: Adding Foreign Sector: We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Consequently, smaller amount of goods will be produced and therefore fewer capital goods like machinery will be indeed with the result that fixed investment will tend to fall. There is no saving S. An example of a tax collected by the government as a leakage is and an injection into the economy can be when the government redistributes this income in the form of , that is a form of government spending back into the economy. National income is also bound to rise in future. With reduced money receipts, firms will hire fewer workers or lay off some workers or reduce the factor payments they make to the suppliers of factors such as workers.
By using its budget therefore the government can influence the levels of income, output and expenditure for the economy as a whole. 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. Thus the circular movement of income and expenditure in the economy continues, leading to equalization in the gross national product and gross national income. By tracking the injections into and withdrawals from the circular flow of income, the government can calculate its national income which is the wages and other forms of income received by households for their services. In other words, the flow of money income will not always continue at a constant level. Economists therefore call savings a leakage from the money expenditure flow.