UNIT–IV-1

CLOSED ECONOMY &OPEN ECONOMY

CIRCULAR FLOW OF INCOME
Dr.L.Krishna Veni
CLOSEDECONOMY&OPEN ECONOMY

● http://www.preservearticles.com/201103144509/close
d-economy-and-open-economy.html
Closed Economy
● Closed economy is an economy, which does not have
any sort of economic relation with rest of the world but
is confined to itself only.
A closed economy does not enter into any one of the
following activities:
● (i) It neither exports goods and services to the foreign
countries nor imports goods and services from the
foreign countries.
● (ii) It neither buys shares, debentures, bonds etc. from
foreign countries nor sells shares, debentures, bonds
etc. to foreign countries.
● (iii) It neither borrows from the foreign countries nor lends
to the foreign countries.
● (iv) It neither receives gifts from foreigners nor sends gifts
to foreigners.
● (v) Normal residents of a closed economy cannot go to
other countries to work in their domestic territory. No
foreigner is allowed to work in the domestic territory of a
closed economy.
● Due to all these seasons, Gross Domestic Product and Gross
National Product are the same in a closed economy.
Open Economy
● It is one, which is not only involved in the process of
production within its domestic territory but also can
participate in production anywhere in the rest of the
world.
An open economy involves itself in the following
activities:
● It buys shares, debentures, bonds etc. from foreign
countries and sells shares, debentures, bonds etc. to
foreign countries.
● It borrows from foreign countries and lends to foreign
countries.
● It can send gifts and remittances to foreigners and can
receive the same from them.
● Normal residents of an open economy can move or be
employed and are allowed to work in the domestic
territory of other economies.
● Due to these reasons, Gross Domestic Product and
Gross National Product are not same in an open
economy. It is to be noted that at present all economies
of the world are open economies.
 Circular Flow of Income-
Different Models

Source-Macroeconomics- Theory & Policy

N.D.Dwivedi
CIRCULAR FLOW MODELS OF THE
ECONOMY

● TWO SECTOR MODEL

● THREE SECTOR MODEL
● FOUR SECTOR MODEL
HOUSEHOLD (Consumption) Sector

● They are the owners of all factors of

production and the returns on their factors of
production
● They are the consumer of all the consumer
goods and services
● They spend their total income on goods and
services produced by the firms-if they save it
flows to firms
Business Firms(Investment)Sector

The business firms on the other hand, are

assumed to have the following features and
functions-
● They hire the factors of production
● They use them as inputs and produce the
goods and sell the goods to the
households
Assumptions
● Households spend their total income on consumer &
capital goods produced by the firm
● Firms produce goods and services only as much as
demanded by the households
● Firms make factor payments to the households as rent,
wages ,interest &profits
● There is no inflow or outflow of income or of goods and
services from any outside services
 Circular flow of Income and Expenditure
–Two Sector Model
● Interdependence of Household Sector and the Business
Firms
● Withdrawals and injections in the circular flows
● Y= FP
● FP = w+r+i+p
● w+r+i+p = V=M
● V(Value of output)=M (Money flows)
=Y(Income)
● Y(Households)=FP =V
 Withdrawals (Leakages), Injections(Additions) & The
Size of Income Flows

● The magnitude of income and expenditure

flows is determined by the size of the
society’s income & the economic
expenditure, the larger the size of flows and
vice versa
● In reality , however there are leakages from
and additions to the circular flows of income
and expenditure
Withdrawals
The leakages are also called as withdrawals
The TWO –SECTOR MODEL, a withdrawal is the amount
that is set aside by the households and firms and is not
spent on the domestically produced goods & services
over a period of time
Ex-For old age or a provision against the loss of job
Saving is a withdrawal
Injections(Additions)

● The savings are ultimately spent in the form of

investment, they take the form of injections
● Injection is the amount spent by households and firms
in addition to their regular incomes and receipts
● An injection by the households is the expenditure that
they make in addition to what they receive from the
firms as factor incomes
Firms’ Injections(+) Firms’ Withdrawals(-)

Factor Payments

Withdrawals and
H Injections in the Circular F
Flows

Household Consumer Expenditure Household

Withdrawals(-) Injections(+)
Two Sector Model With Savings
● ASSUMPTIONS
● Households supply finances directly to the firms
● Households do save a part of their income for
investment

● Y=C+S
● Y=C+I
THREE SECTOR MODEL
Government sector adding to the two
sector model =Y=C+I+G
G-GOVERNMENT SECTOR
● This three sector model depicts a more realistic economy
as the government which plays an important role in the
economy
Role of Government – 3 FUNCTIONS
● Protection
● Peace
● Maintenance of Law &Order& Spending on important
economic& social overheads
 Budget-Instrument of Government
Budget(Fiscal Policy) deals with
PUBLIC REVENUE&PUBLIC EXPENDITURE
PUBLIC REVENUE
● Taxation- Direct & Indirect

● Profits from Public Enterprises

● Prices,Fees,Fines,Penalties,Escheats

PUBLIC EXPENDITURE
Defence, Economic, Social & cultural Expenditures
FOUR SECTOR MODEL
● Adding FOREIGN SECTOR to the three sector model
● Foreign sector deals with –

1. FOREIGN TRADE- Exports & Imports-

Goods Trade & Service Trade
1. INFLOW & OUTFLOW OF CAPITAL (FDIs, FIIs, MNCs,
Lending &Borrowing , Gifts& Remittances/Payments)
2. Loans&Grants
● Y=C+I+G+(X-M)
ASSUMPTIONS
● The external sector consists of only exports and
imports of goods & services
● The export and import of goods and non labor services
are made only by the firms&
● The households export only labor

● Exports represent injections into the economy

● Imports represent withdrawals from the circular

flows
Trade Balance/Net
● Balance of Trade=Equilibrium
=Receipts -Payments=0
Disequilibrium=
● R >P
● R<P
 Circular Flow of Income & Expenditure
In Four Sector Model

● Y=C+I+G+(X-M)
● Y-Income
● C-Consumption Sector
● I- Investment Sector
● G = Government Sector
● (X-M) Foreingn Sector