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circular flow of income in a closed economy and an open economy
- The circular flow of income refers to the interrelationships between the different sectors of an economy and how money, goods, and services flow among them.
- The circular flow model consists of two main sectors: the household sector and the business sector.
- The household sector provides labor and capital to the business sector in exchange for wages, rent, interest, and profits.
- The business sector, in turn, uses these inputs to produce goods and services, which are then sold to the household sector and other businesses.
- This flow of money from the household sector to the business sector is referred to as expenditure.
- The flow of goods and services from the business sector to the household sector is referred to as output.
- The flow of income from the business sector to the household sector is referred to as income.
- In this way, the circular flow of income, expenditure, and output represents the continuous cycle of production, consumption, and income generation that drives an economy.
- The model helps to understand how changes in spending and production in one sector can impact the other sectors and the overall economy.
- Open economy: an economy that is involved in trade with other economies.
- Closed economy: an economy that does not trade with other economies.
Circular flow of income in a closed economy and an open economy
injections and leakages (multiplier not required)
- Injections: an addition to the circular flow
- investment spending,
- government spending,
- exports
- Withdrawals/Leakages: a leakage (deduction) from the circular flow of income
- saving,
- direct taxes,
- imports
- In the long run, links can occur between changes in injections and leakages.
- For example, a rise in investment leads to an increase in income. As people become wealthier, they have a tendency to save more, which provides funding for additional investment.
- An increase in government spending may result in an increase in tax revenue due to higher income levels.
- A rise in exports also boosts income levels. As income grows, people tend to spend more not only on domestically produced goods, but also on imported products.
equilibrium and disequilibrium (marginal and average propensities not required)
- Equilibrium income is the level of income where the flow of spending in the economy is sufficient to purchase all the goods and services that are produced.
- At this level, injections equal withdrawals, and the economy is in balance.
- When the economy is at equilibrium income, there is no tendency for either economic expansion or contraction.
- Disequilibrium income occurs when injections and withdrawals are not in balance.
- If injections exceed withdrawals, the economy experiences an increase in aggregate demand and economic expansion. This results in a higher level of income than the equilibrium level.
- If withdrawals exceed injections, the economy experiences a decrease in aggregate demand and economic contraction, leading to a lower level of income than the equilibrium level.
- If the economy is at disequilibrium income, there is a tendency for it to move back towards the equilibrium income level.
- For example, if injections exceed withdrawals and the economy experiences an increase in aggregate demand, this will lead to an increase in prices, which will cause the withdrawals to increase and the injections to decrease. In this way, the economy will move back towards the equilibrium income level.
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