At StudySmarter, we have created a learning platform that serves millions of students. Meet the people who work hard to deliver fact based content as well as making sure it is verified. The three major flows in the economy are goods, money, and services. The government sector is made up of economic activities by the municipal, state, and federal governments. Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work.
As a result, firms won’t be able to sell all the goods and services they produce, resulting in lower incomes and national revenue. On the other hand, financial institutions in the economy facilitate the lending or borrowing of money. The circular flow model can be expanded in several ways depending on the economic sectors involved. Here are the most common combinations of economic factors in the circular flow. The financial market also plays an important role in a three-sector economy, as the government saves a part of their earned income and deposits the same in the financial market. Besides, the government also borrows money from the financial market so it can meet its expenditures.
It’s also used to gauge the interconnectivity between sectors because a robust economy will have interaction between components. The relationship between a government’s taxation policies and a household’s consumption spending will have a direct impact on a business’s ability to sell goods. Mosttextbook introductions explain circular flow of national income with five sector model of the model start with a simple division of an economybetween households and business, and I will copy that format here.
The Market Mechanism, Market Failure & Government Intervention
The money spent on imports is leakage and is an activity of the foreign sector. When the value of leakages EXCEEDS the value of injections, the economy is slowing. More money is being removed (or withdrawn) from the economy than is being pumped into it. As a result, GDP is likely falling, unemployment is on the rise and prices and probably dropping (lower inflation).
The economy often moves in a circle as money flows from one sector to another. Households spend money and businesses use that money to create new, better products for the households to buy in the future. Money also flows into the circle in a four-sector model through exports (X) that bring in cash from international buyers from the foreign sector. This indicates that the two-sector or three-sector models represent domestic activity only. The foreign sector is different from the domestic sector because there may be administrative inefficiencies that result in lost cash flow due to import taxes, duties, or fees. The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents.
Flashcards in Circular Flow of Income
This is a leakage because the saved money cannot be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp. This is the simplest representation of circular flow of income. In this simple circular flow model, only two sectors are considered, i.e., households and firms. This economy will be considered as a free market closed economy because of the absence of the government and the foreign sectors.
The foreign sector
- This includes banks and other institutions that provide cash flow via lending services.
- This means that, on average, for every $1 of income households earn, they are saving somewhere between 5 and 9 cents.
- The leakages are the savings and taxes while the injections are the investment and government spending.
- Let’s look at the relationship between injections and leakages.
- The land market, the labour market, and the capital market are examples of factor markets.
A certain portion of the company’s profits is given to the government in the form of taxes. Apple may benefit from government programs or subsidies in some cases so part of these tax dollars may indirectly benefit the company. It would lead to a reduction in household spending and cause a decrease in GDP if businesses decided to produce less.
Foreign Sector
This diagram shows how money often flows from one sector to another, awarding benefits along the way. A fully functioning circular model will continuously move funds so each sector can operate appropriately. Movingtowards a more complete version of the model, there are a total of 5 sectors inthe circular flow model to explain. The first two, households and businesses, arealready explained above.
For example, according to the Australian Bureau of Statistics (ABS), in December 2021, households took out nearly $33 billion of new home loans — either to buy a property to live in or to rent out. This is a massive injection into the economy but is excluded from the model. In the economy, goods and services move in one direction while money flows in the other way.
- Flows from households and firms to government are in the form of taxes.
- A country may choose to reduce its imports and scale back certain government programs if it realizes that it has a deficient national income.
- The circular flow diagram is an abstraction of the economy as a whole, which suggests that the economy can reproduce itself.
- Saving affects the circular flow of income by causing a leakage, as money saved by households is not spent on goods and services, reducing the overall flow.
Circular Flow of Income:
It describes the current position of an economy regarding how its inflows and outflows are used. A country may choose to reduce its imports and scale back certain government programs if it realizes that it has a deficient national income. Consider a circular flow model involving Apple employees and Apple product consumers. We’ll also include the government in this example to form a three-sector circular flow model. Companies increase output and hire more workers to meet the increase in demand as consumer spending increases. The increase in employed people means more wages and more people spending, leading producers to increase output again, continuing the cycle.
Government spending (G) is the spending of the government on public projects. Government spending is an injection and is the activity of the government sector. Consumption (C) is the spending of households on buying goods and services for personal use. We now include the government into our simplified model of the economy. Money, spending, and benefits moved around in an endless loop. Your neighbor has also contributed to the economy by leaving home each day and working, which they were able to do without worrying about having to walk their dog.
The government sector
You’ve contributed to the economy with your time spent, and you contribute again when you use that $5 you’ve earned to buy yourself a much-coveted treat. An important development was John Maynard Keynes’s 1933 publication of the General Theory of Employment, Interest and Money. Keynes’ assistant Richard Stone further developed the concept for the United Nations (UN) and the Organisation for Economic Co-operation and Development to the systems, which is now used internationally.
Conversely, the total flow of money into the sector is equivalent to the total GDP expenditure. Households send money to firms for goods and services in a process called consumption. The financial sector can also invest in firms to help companies increase their output. A visual presentation of the circular flow of income in an economy is called a circular flow diagram.
They want to hang on to their funds because they are unsure whether they can continue to earn the same level of income. I’ve also written about how the Circular Flow of Income Model helps us understand economic growth. Vaia is a globally recognized educational technology company, offering a holistic learning platform designed for students of all ages and educational levels.