We called the economy illustrated in Figure 3 an open economy because it is open to trade with the outside world. As we have already seen, a free market economy consists of two components, or sectors, as they are called. Imports are goods and services produced overseas but sold in Australia and these payments represent leakages from the circular flow. First, take the circular flow between the household sector and the government sector. The money to buy these goods and services flows out of the country. Similarly, if we study production of a firm or of an industry , our analysis is micro study but if we study problems of production of the whole economy, our analysis is macro study. It sets standards for weights and measures, and the monetary system.
They also consider households to be saving when they repay debts. These days financial markets around the world have become well integrated. In the meantime, households spend this income on goods and services in the goods market and in exchange receive the goods and services themselves the right hand side of the flow. Consumers and firms are linked through the product market where goods and services are sold. First of all let us take the circular flow between the household sector and Govt sector. Leakages withdrawals from the circular flow Not all income will flow from households to businesses directly. Usually this borrowing takes the form of sales of government bonds and other securities to the public or to financial intermediaries.
Savings: On the average, households spend less each year than they receive in income. Firms spend on investment in order to expand their productive capacity in future. Examples are: National income, national savings, general price level, aggregate demand, aggregate supply, inflation, unemployment, etc. This will lead to the fall in total incomes of the households. They tend to reduce consumption and saving of the household sector. In an economy, households supply factors to the firms producing units. This Govt purchases firms an injection in the circular flow of income and taxes are leakages.
Government purchases goods from firms and labour services from households. Food for thought: If you look at it, those Apple workers might just buy Levis jeans sourcing cotton from Raymonds mills and essentially that revenue might just come back in some form but not completely. Thus, goods and services available for domestic purchase is Y+M. 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. On the other hand, if net taxes exceed government purchases the government will have a budget surplus. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. Easy to see that the Foreign Sector Transforms a closed circular flow of income to an open economy.
With this income factors of production i. 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. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors—the household, the business and the government. We will be looking at the actions and behaviour of firms and households, and how governments interact with them. Figure 1 Circular flow of income We can see this circular flow in Figure 1.
The business sector sells the entire output to households. Circular Flow of Money between Household and Business Sectors : We begin with a simple hypothetical economy where there are only two sectors, the household and business. 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. On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow or money. It simply establishes and protects property rights. Think about it, then click. As already noted, taxes are a leakage from the circular flow.
As we know money acts as a medium of exchange. The government deficit must be financed by borrowing in financial markets. With the inclusion of this sector, the economy becomes an open economy. Money invested by firms into purchasing capital stock. A leakage occurs in the income flow and an injection in the expenditure flow. Jot down your answer and then follow the link. Financial markets are pictured in the center of the circular-flow diagram in the above figure.
In case of cash deficit, the government borrows from the capital market to maintain a balance in the economy. On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. The Circular Flow in a Two-Sector Economy 3. These government expenditures are injections into the circular flow of money. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government.
The government is the firms, as all firms are owned by the government state. This becomes injection in circular flow as shown in Fig. Taxes on business firms will also curtain investment. The circular flow of income in different sectors can be expressed as follows: Household Sector Receipts The household sector receives factor income in the form of rent, wages, interest, and profit from the business sector. Government expenditure represents an injection as it goes towards collective goods and services. But the actual economy is an open one where foreign trade plays an important role. Thus total sales again equal production of firms.
They may also be families. In case the savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled by investment. Business sector given money for the purchase of scarce economic resources from the resource market and also receives money by selling goods and services in the product market. Investment is any current expenditure that is made in order to obtain benefits in the future. Money flows to workers in the form of wages, and money flows back to firms in exchange for products. It makes payments for import of goods and services from firms and the government. Circular money flow with saving and investment is illustrated in Fig.