This is a basic identity in national income accounts which needs to be carefully understood. It may, however, be pointed out that this flow of money income will not always remain the same in volume. Here we will concentrate on its taxing, spending and borrowing roles. Imports leak out of the economy because the money in our country that's used to buy imports from other countries goes out of our economy and into their hands. Thesepayments also income earned by households in the form of wages,rents, interest, and profits.
A point of the frontier line indicates the efficient use of available inputs, while a point beneath the curve shows inefficiency. When the entire diagram is created, it shows the money, which comes from individuals or households through purchases and factors, become the income of the businesses. There are many examples of market systems. By tracking these flows, we can understand the links between different markets; by understanding these links, we gain insight into the functioning of an economy. Thus the circular flow of money highlights the importance of adopting compensatory fiscal policy. Again, firms coordinate and employ different factor units which are owned by households. In economics, leakage refers to outflow from a model.
The circular flow reveals that there are several different ways to measure the level of economic activity. Government welfare benefits, spending on infrastructure. Firms use factors such as capital, labor, and land from households so they can produce the goods households purchase. Government borrowing increases the demand for credit which causes rate of interest to rise. Factor incomes Factors of production earn an income which contributes to national income. Households spend some of their disposable income and save the rest. On the other hand, If I+G exceed S+T there are inflationary tendencies in the economy which can be checked by encouraging saving and increasing government, revenues through taxation.
The level of injections is the sum of government spending G , exports X , and investments I. It has sent goods to Australia in exchange for the promise that it can claim Australian products at some future date. In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. Firms use that labor to produce pizzas and sell those pizzas to households. Initially, we assume that the economy is composed of only twosector, business and household. However, the flow of money and the flow of goods and services move in opposite directions see illustration below.
On the other hand, if injections into the circular flow of money exceed leakages, the money supply is increased in the economy. There are two sides to every transaction. That is, there will be net capital inflow into the economy to finance higher capital formation in the economy. In other words, a market system is a place virtual or physical that facilitates the matching of buyers and sellers. People in households buy goods and services from businesses as well as sell their labor, land, and capital in exchange for income. The total flow of dollars from the firm sector measures the total value of production in the economy. Condition for the Constancy of Circular Money Flow: Now the question arises what is the condition for the flow of money income to continue at a steady level so that it makes possible the production and subsequent flow of a given volume of goods and services at constant prices.
In every sector of the circular flow, accounting rules tell us that the flow of money in must equal the flow of money out. 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. Assumptions The Basic Circular Flow of Income Model builds on three major assumptions. If we lend to other countries, then the flow goes in the other direction. Saving-Investment Identity in National Income Accounts: Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade.
Another method of financing Government expenditure is borrowing from the financial market. Circular Income Flows in three Sector Economies with Government Sector : In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. On the contrary, if investment expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest savings increase and become equal to planned investment expenditure. Investment refers to the purchase of goods and services that, in one way or another, help to produce more output in the future. The government taxes firms and consumers, and then spend money, e.
To conclude, the circular flow of money possesses much theoretical and practical significance in an economy. This is a critical aspect because it prevents money from leaking out of the circular flow. It is important to note that this assumption implicitly states that there are no government, financial or foreign sectors. The financial sector is also linked to the government sector and the foreign sector. As a result, circular flow of income does not continue at a steady level in a free-enterprise capitalist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy. New spending C generates new income Y , which generates further new spending C , and further new income Y , and so on. Now, what will happen if planned investment expenditure falls short of the planned savings? Government purchases goods and services just as households and firms do.