The circular flow diagram is an abstraction of the economy as a whole. Leakages and injections can occur in the financial sector, government sector and overseas sector: 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 their money. Thus, Net Exports = Aggregate Domestic Product (Y) – Aggregate Domestic Expenditure. Another important conclusion that can be drawn from national income account identity incorporating Government expenditure relates to the condition for equilibrium in the financial market. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp. Content Filtrations 6. Injections increase the flow of income. Firms spend on investment in order to expand their productive capacity in future. The government borrowing through its effect on the rate of interest affects the behaviour of firms and households. In order to make our analysis simple and to explain the central issues involved, we take many assumptions. The foreign sector comprises (a) foreign trade (imports and exports of goods and services) and (b) inflow and outflow of capital (foreign exchange). In this video I explain the Circular Flow Matrix and how products, resources, and money flow in a market economy. These materials and energy are used by households and firms a like to create products and wealth. The three-sector model adds the government sector to the two-sector model. This video lesson is on the circular flow diagram, which describes the circular flow of money in a free market economy. Circular Flow of Income and Expenditure The circular flow of income and expenditure clearly presents the flow of resources and payments among the sectors of the economy. In free market economies there exists a set of institutions such as banks, insurance companies, financial houses, stock markets where households deposit their savings. The diagram answers this question. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. [12] In the former case, no economic growth occurs, while in the latter case, more is produced than is needed to maintain the economy at the given level, making economic growth possible. [5], Of course, the total economy is much more complicated than the illustration above. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. National income identity with government expenditure is, In the expression (vi), the left hand side (Y-C-G) represents national saving or simply saving (S). In is thus clear that, in the monetary economy, there will be flows of money corresponding to the flows of economic resources and the flows of goods and services. "Circular flow diagrams." If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income. Transfer payments are treated as negative tax payments. Circular Flow of Money with the Foreign Sector: So far the circular flow of income and expenditure has been shown in the case of a closed economy. B) goods and factor markets are independent. [25], The abstraction ignores the linear throughput of matter and energy that must power the continuous motion of money, goods and services, and factors of production. So we, the first picture we're going to make here is of a, an economy, that's very simple. The Circular Flow in Action. If exports exceed imports, trade balance (NX) is positive and if exports fall short of imports, the trade balance (NX) is negative. This will lead to the fall in total incomes of the households. In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households. Y). Daraban, Bogdan. Backhouse, Roger E., and Yann Giraud. Rearranging the national income account identity of the open economy (Y=C+1+ G + NX) we have NX = Y- (C + I + G), Where C + I + G is aggregate domestic expenditure. Goods and services produced within the domestic territory which are sold to the foreigners are called exports. In an economy households provide factors of production, such as labour, to firms. Firms use these factors to produce goods and services which they sell to the households. It's got just households on … This leads to a cumulative rise in employment, income, output, and prices over a period of time. 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