Think of this diagram as representing the interaction of many households with many firms. The circular flow of income and expenditure refers to the process whereby the national income and expenditure of an economy flow in a circular manner continuously through time. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports exports minus imports. But he wants to think a little bit more formally about his economy and he starts setting up some institutions that start to resemble things that we would see in more complex economies. Everything here is on an annual basis. In this case, consumer spending is converted into business revenue. The problem with this approach is that not everything that households, businesses, and the government purchases every year is actually produced in their country.
Note that government spending G includes its buying of labour from factor market, buying of goods and services from product market, and transfer payments to the household sector. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income. This represents a simple economic model; it is a closed economy without any government intervention. Open Economy Let's open up the economy to the foreign economies. In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services.
These dollars are then available for firms to borrow to build new factories, install up-to-date equipment, and so on. Figure 3 shows that taxes flow out of the household and business sectors and go to the government. The four-sector economy is composed of following sectors, i. For all exports of goods, the government receives payments from abroad. Famous Figures and Diagrams in Economics. Well, total expenditures come out to what? Government welfare benefits, spending on infrastructure. Therefore, the spending goes back to firms.
Money flows to workers in the form of wages, and money flows back to firms in exchange for products. 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. And it diverts gross domestic product from consumption and investment to government purchases. He has one house and he has some land on which crops can be grown. Now we take the household, business and government sectors together to show their inflows and outflows in the circular flow. The idea is the same either way. Toolkit: As individuals and firms buy and sell goods and services, money flows among the different sectors of the economy.
The business sector, in turn, makes payments to the households for the services rendered by the latter to the business-wage payments for labour services, profit for capital supplied, etc. It shows how households purchase goods and services from firms by using the income they earned from firms by working for them. Note that buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products. Financial Market: As we have seen, households tend to spend less each year than they receive in income, whereas firms tend to spend more than they receive from the sale of their products. The various components of national income and expenditure such as saving, investment, taxation, Govt, expenditure, exports, imports, etc.
On the other hand, consumption tends to increase employment, income, output and prices that lead to inflationary tendencies. As a result of this, price of the car goes up to Rs. Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. Suppose, an excise duty on Indica car has been imposed. Secondly, national income data help in measuring changes in the standard of living over time. The blue line shows households spend their money on goods and services produced by firms. Taxes are household sector income that is diverted to the government sector.
Likewise, people of other countries purchase goods and services not produced domestically i. An injection of new spending will increase the flow. But households may not spend all their income on current consumption and firms do invest for future production. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. In Figure 2 there is a capital or credit market in between saving and investment flows from households to business firms. In such a case the Govt reduces the public debt and supplies fund to the capital market which are received by firms. If Govt purchases exceed net taxes then the Govt will incur a deficit the difference between taxes precede and public expenditure.
Basis of Flow of Funds Accounts: The circular flow helps in calculating national income on the basis of the flow of funds accounts. As far as the national accounts are concerned, it is as if firms sent these funds to the financial market and then borrowed them back again. Exports are an injection or inflows into the economy. Government borrowing is the amount of funds borrowed by the government in the financial markets. Households spend some of their disposable income and save the rest. He rents out the land to the firm, so he gets.
A four-sector economy is called an open economy in the sense that the country gets money by sending its goods outside i. Firstly, while formulating national economic plans and policies, national income statistics are taken into account. This is because first a company has to pay corporate income tax T c to the government out of its earned income. Taxation is a leakage from the circular flow and government purchases are injections into the circular flow. Finally, the government creates flows both to the households and the businesses, offering services and receiving funds. Govt, expenditure on the purchase of goods and services constitutes an important source of injection.