Circular Flow of Economy

|This article explains how an economy can become in a disequilibrium and how recessions and booms happens in a market economy. | |The circular flow of income model is a model used to show the flow of income through an economy. Through showing the leakages in| |the economy and the injections, the different factors affecting the economic activities are apparent. Just like a leakage in a | |fish tank a leakage in the economy leads to a decrease in economic activity.

| |And just like an injection into a fish tank where the water level rises, an injection in an economy leads to an increase in | |economic activity. To understand how the circular flow of income can be used to show disequilibrium in the economy you must | |first understand what disequilibrium is. Disequilibrium is the state where economic activity is not equal, that is where | |leakages > injections or when leakageswhereas the state of equilibrium is when leakages=injections.

Hence disequilibrium is | |when the savings are either greater or less than the investment. | |[pic][pic][pic][pic] | |The basic circular flow of income model consists of six assumptions: | |The economy consists of two sectors: households and firms. | |Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). | |All output (O) produced by firms is purchased by households through their expenditure (E). | |There is no financial sector. | |There is no government sector. | |There is no overseas sector.

| |In the simple two sector circular flow of income model (Fig 1) the state of equilibrium is defined as a situation in which there| |is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is: Y = E = O. | |This means that all household income (Y) is spent (E) on the output (O) of firms, which is equal in value to the payments for | |productive resources purchased by firms from households. This can be shown in an example where John earns $100. 00, he doesn’t | |save it and spends it all on the goods and services (O) provided by the firms.

| |Table all leakages and injections in five sector model: | |LEAKAGES | |INJECTION | | | |Saving (S) | |Investment (I) | | | |Taxes (T) | |Government Spending (G) | | | |Imports (M) | |Exports (X) | | | |The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector | |model where there are six assumptions the 5 sector circular flow runs on the basis that all the 6 assumptions are relaxed. Since| |the first assumption is relaxed there are 3 more sectors introduced.

The first is the Financial Sector that consists of banks | |and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. | |In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for | |households to save there money. 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. 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. | |The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of| |local, state and federal governments in Australia. The leakage that the Government sector provides is through the collection of | |revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a leakage because| |it is a leakage out of the current income thus reducing the expenditure on current goods and services.

| |The injection provided by the government sector is Government spending (G) that provides collective services and welfare | |payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the | |economy can be when the government redistributes this income in the form of welfare payments, that is a form of government | |spending back into the economy. | |The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to| |an open economy.

The main leakage from this sector are imports (M),in the context of Australia imports represents spending by | |Australian residents into the rest of the world. The main injection provided by this sector is the exports of goods and services| |where again in the context of Australia generates income for the exporters from overseas residents. | |An example of the use of the overseas sector is where Australia exports wool to China, China pays the exporter of the wool (the | |farmer) therefore more money enters the economy thus making it an injection.

Another example is where China processes the wool | |into items such as coats and Australia imports the product by paying the Chinese exporter, since the money paying for the coat | |leaves the economy it is a leakage. | |In terms of the 5 sector circular flow of income model (Fig 2) the state of equilibrium occurs when the total leakages are equal| |to the total injections that occur in the economy. This can be shown as: >Savings + Taxes + Imports = Investment + Government | |Spending + Exports,or: S + T + M = I + G + X.

| |This can be further illustrated through the fictitious economy of Noka where: | |S + T + M =I + G + X | |$100 + $150 + $50 = $50 + $100 + $150 | |$300 = $300 | |Figure 3: Equilibrium | |Therefore since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be | |contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of | |total injections. By giving values to the leakages and injections the circular flow of income can be use to show the state of | |disequilibrium.

Since disequilibrium can be shown as: >S + T + M I + G + X, Therefore it can be shown as one of the below | |equations where: | |Total leakages > Total injections | |$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X) | |Or | |Total Leakages < Total injections | |$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X) | |The effects of disequilibrium vary according to which of the above equation they belong to. | |If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction | |in the overall economic activity.

But if S + T + M < I + G + X the levels of income, output, expenditure and employment will | |rise causing a boom or expansion in economic activity. | |But to manage this problem if disequilibrium was to occur in the five sector circular flow of income model, changes in | |expenditure and output will lead to equilibrium being regained. An example of this is if: S + T + M > I + G + X the levels of | |income, expenditure and output will fall causing a contraction or recession in the overall economic activity.

| |[pic][pic][pic][pic] | |As the income falls (Figure 4) 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. This will lead to a fall in the leakages until they equal the injections | |and a lower level of equilibrium will be the result. | |The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and | |output will greatly rise causing a boom in economic activity.

As the households income increases there will be a higher | |opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and | |they will be able to spend more on imports. | |In this case when the leakages increase they will continue to rise until they are equal to the level injections. The end result | |of this disequilibrium situation will be a higher level of equilibrium. | |This is how the circular flow of income model can be used to explain how disequilibrium in the economy occurs. |