The circular flow model is an intentional simplification of any actual market economy. They are expenditure s incurred by the household sector to purchase goods from foreign countries. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. This can be represented by the money flow from the financial market to the Government and is labelled as Government borrowing To avoid confusion we have not drawn this money flow from financial market to the Government.
The idea that businesses make money by selling products to households is probably familiar. The ignores the linear throughput of matter and energy that must power the continuous motion of money, goods and services, and factors of production. Total expenditure flow in the economy is now the sum of consumption expenditure denoted by C , investment expenditure I and Government expenditure denoted by G. Thus these two flows are interrelated and interdependent through exchange. Likewise, the products that households need and want come from businesses, and the factors of production that businesses need in order to operate come from households. These resources are distributed among the various types of producers. This situation is often illustrated using a diagram that allows us to visualize the basic workings of the overall economy.
Thus, the money that households contribute to businesses in the form of purchases comes back to households in the form of payment for labor. In 1758 he drew an early version of the circular flow diagram to explain to the king how resources, money, and goods moved between farmers, landlords, and merchants. The idea of the circular flow was already present in the work of. As mentioned above, saving a part of income means it is not spent on consumer goods and services. It also receives royalties, interests, dividends, etc. These complications are caused by injections and leakages. The fact that the arrows on the money lines and the arrows on the product lines go in opposite directions simply represents the fact that market participants always exchange money for other stuff.
This money does not flow through the economy but is simply in storage. The consumers become recipients of the goods produced by the final goods producers. On the other hand, the business sector makes payments to the foreign sector for imports о capital goods, machinery, raw materials, consumer goods, and services from abroad. Foreign consumers and firms will, however, also wish to buy domestic products, called exports X , and this is an injection into the circular flow. In the model taxes and savings leakages have reduced consumption to Rs. This is how the economy functions. The household sector owns all the factors of production, that is, land, labour and capital.
Hous ehol ds pur chas e good s and serv ices from other coun tries , like tran spor tatio n equi pmen t, book s, computer programs, etc. Thus, through investment expenditure by borrowing the savings of the households deposited in financial market, are again brought into the expenditure stream and as a result total flow of spending does not decrease. Just as no animal can live on its own waste, no economy can recycle the waste it produces without the input of new energy to reproduce itself. The Circular Flow in a Three-Sector Economy 4. This model is a simplification of economic activity, but it allows us to understand some central facts about market economies. Government expenditure takes many forms including spending on capital goods and infrastructure highways, power, communication , on defence goods, and on education and public health and so on.
Circular Income Flow in a Two Sectors economy: Real flows of resources, goods and services have been shown in Fig. Thus, the functioning of the economy consists in the production of goods and the services by the factors of production and production units. That income is spent on the goods and services businesses produce. To understand the identity vi , we break up its left hand side representing national saving into two parts, namely, 1 private saving Y- T- C and 2 public saving i. These government expenditures are injections into the circular flow. Both households and businesses take in money, and both of them spend money on goods and services.
In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular flow of income. They are bound to one another by relationships that, in being played out, dictate the working of the economy. The model includes households, businesses and governments. By net capital outflow we mean foreigners will borrow from domestic savers to finance their purchases of our exports. They'll even set aside some of the taxes to help Margie and Dave later on in life when they're retired.
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. In reality, however, households allocate a part of their incomes for future use like providing money for old age. However, in the four sector open model leakage would consist of imports besides savings and taxes and injections would consist of exports besides investment and government expenditure. They are also linked through the factor market where the factors of production are sold and bought. This leads to a cumulative decline in employment, income, output, and prices over time.
As already noted, taxes are a leakage from the circular flow. Cantillon probably wrote his only surviving work, Essai sur la Nature du Commerce en Général An Essay on Commerce in General , in the year 1732 or thereabouts, but it was not published until 1755 in France. Inflationary and Deflationary Tendencies: Leakages or injections in the circular flow disturb the smooth functioning of the economy. Two basic types of markets exist in any market economy: resource markets and product markets. Such leakages are saving, and inflows or injections are investment which equals each other.
The factors of production - land, labor, capital, and entrepreneurship - have prices that we call rent, wages and profit. In order to obtain a clear idea of the relations between the numerous economic units in a country, it is best to reduce them to homogeneous groups. It sets standards for weights and measures, and the monetary system. Herein lies the greatest importance of Keynesian approach. The model also does not account for situations in which the levels of supply and demand fluctuate. They are expenditures incurred by the household sector to purchase goods from foreign countries.