If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of interest, investment increases and both become equal. On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. In the open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. C+S identity is related to the aggregate supply of an economy. Aggregate demand is the summation of consumption expenditure on newly produced consumer goods by households and on their services C , and investment expenditure on newly produced capital goods and inventories by businessmen I.
Please help to this article by more precise citations. In order to avoid further inventory accumulation, they will reduce production. We further assume that there are no inter-households borrowings. Write their answers on a projected copy of the Venn diagram. Figure 4 shows the circular flow of the four-sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the figure, and investment, government purchases and exports as injections into the circular flow on the left side of the figure. Importance of Monetary Policy: The study of circular flow also highlights the importance of monetary policy to bring about the equality of saving and investment in 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. This leads to an equilibrium in the circular flow as the level of demand meets the level of supply in the economy. Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. Study of Problems of Disequilibrium: It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can be studied. Countries in a more advanced state of development, with a medium , generate their income mostly in the secondary sector. Firms spend on investment in order to expand their productive capacity in future. Government policy which influences the level of spending in the economy.
Thirdly, we assume that the economy neither imports goods and services, nor exports anything. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. Proportional tax refers to a type of tax that is levied at the same rate, regardless of the amount earned by individuals. As stated earlier, taxes paid by the household and the business sector are the leakages from the circular flow. The term Investment means the production of new capital goods leading to capital accumulation. This leads to the continuous circular flow of national income within the economy. Explain that in some cases some organizations may fit into more than one grouping and then they should go into the areas that connect both circles.
The economy is at less than full employment level of output. Built by Sir Titus Salt. However, an eminent British economist J. The equilibrium level of income is 2500 millions. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow. Balanced Budget Multiplier : Till now we have discussed the change produced in national income due to government expenditure and taxes separately, while keeping the other variable at constant. Transfer payments are treated as negative tax payments.
It also receives royalties, interest, dividends etc. Now we introduce taxation in the model to equate the government expenditure. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government. It is thus clear from the above analysis that the flow of money income will continue at a constant level only when the condition of equality between planned saving and investment is satisfied. Condition for the Constancy of Circular Income 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.
The level of economic activity in an economy will determine the levels of income, output and expenditure for that economy as a whole. Today the tertiary sector has grown to such an enormous size that it is sometimes further divided into an information-based , and even a quinary sector based on human services. There are also flows of goods and services in the opposite direction to the money payments flows. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. When saving exceeds investment or investment exceeds saving, money and credit policies help to stimulate or retard investment spending. Find the new equilibrium level of income in the three sector economy.
On the other hand, the government also makes transfer payments to the household sector in the form of various benefits and services like pension funds, relief, sickness benefits, health, education, and other services. These variables are government expenditure act as injections to income and taxation act as leakage or withdrawals from income. It was a key part of the economy. Thus aggregate demand is less than aggregate supply. Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education, etc.
Falling income, output and employment levels will cause the size of the circular flow to shrink, causing recession. If exports are equal to the imports, then there exists a balance of trade. If the equality between planned savings and planned investment is disturbed by increase in savings, then the immediate effect will be that the stocks of goods lying in the shelves of the shops will increase as some of the goods will not be sold due to the fall in consumption i. The household sector buys goods imported from abroad and makes payment for them which is a leakage from the circular flow. Students may bring up examples of government philanthropy and corporate philanthropy. This is how the economy functions. According to balanced budget theorem, the numerical value of balanced budget multiplier is equal to one.