Describe the circular flow of income for an open economy with Government.

Use the circular flow to demonstrate three different ways of measuring economic activity.

. foreign markets and the government. The households supply the factors for production to the firms. To give a more accurate representation. The term investment. (Turley et al. A more complete open circular flow model also shows the interaction between financial institutions. (Turley et al. shown on the right. and of factors for production. paid in the form of wages. At its most basic the circular flow model.The circular flow of economics shows the movement of resources between consumers and producers. The circular flow model can also be used to show the three different ways of measuring economic activity.. refers to corporate or business expenditure and the inventory build up of raw materials and finished goods. displays the relationship between households and firms. In this regard financial institutions make a monetary withdrawal from the economy. the monetary flow of incomes and of expenditures. The outer circle shows us the flow of goods and services. Macroeconomics is concerned with the inner circle. firms and households to have an accurate measurement of the economy to aid financial decisions such as whether or not to invest money. These factors of production are also referred to as inputs. (Turley et al. It is of great importance for governments. this is known as consumer expenditure. rent or dividends. 2006) Firms finance investment expenditure by borrowing funds from the financial institutions that facilitate household savings. land and capital that firms use to produce goods and services. the circular flow model must incorporate three more elements. foreign markets and the government and the economy. in reality a household may choose to put some of their income into savings. 2006) Financial institutions such as banks facilitate these savings. Households use their incomes to purchase the goods and services supplied by firms.. 2006) In return for these factors of production the households receive an income. namely financial institutions. however they also make an monetary injection into the economy in the form of investments. they supply the labour. . The basic model acts on the assumption that households expend the total amount of their incomes. The basic circular flow model however is too simplistic to be an accurate representation of a country¶s economy. From the diagram we can see how these repeating exchanges result in a circular flow of economic activity.

The government also plays a role in the economy. If the value of exports exceed imports the value is positive. The circular flow model shows that there are three forms of withdrawals. 2003) When the total amount of withdrawal equals injection. or leakages in the economy. open economies alternatively do trade with foreign markets in the form of imports and exports. It invests vast amounts of money in services such as health care. (Turley et al. The difference between imports and exports is known as net exports.Diagram of an open circular flow model with government. To fund this the government implements taxes. this is an example of a transfer payment. investment. (Sloman. 2006) These taxes take money from the economy but then the money may be injected back into the economy by means of the investments they fund. There are also three forms of injections. In this respect imports cause a monetary withdrawal from the economy and exports result in an injection into the economy. savings. The government also funds social welfare from taxes. The reverse . resulting in greater output and a drop in unemployment. income tax on households and tax on expenditures such as VAT. Imports refer to foreign goods and services that are purchased by domestic households and firms. A closed economy is one that does not trade with other economies markets. If there is an excess of injections over withdrawals there is economic growth. government expenditure and exports. where wealth is simply redistributed from one household to another rather then being used for a particular investment or service.. education and law enforcement. whilst the value is negative if the value of imports exceeds the value of exports. while exports refer to domestic goods and services purchased by foreign households and firms. primarily in the form of two categories. taxes and expenditure on imports. the economy is said to be in a state of equilibrium.

³Double counting occurs if the expenditure on intermediate goods is included in the calculation of nation output.occurs when withdrawals exceed injections. the profit of companies and from rented dwellings. and is published annually by the Central Statistics Office entitled National Income and Expenditure. National expenditure is the total of all expenditure by households.307) For example. Then if the furniture goes on to be sold in 2010 the output would be valued at ¼10k also. the economy shrinks and there is a drop in outputs and an increase in unemployment. In Ireland the most common measurements of economic activity are national income and expenditure. 2006) National output is the sum of the value added of production from the economy. 2006. As well as being a representation of a country¶s economy. expenditure or output of a country should result in the same numeric total for each measure. as shown on the right.´ (Turley et al. This approach ensures that when measuring an output. However if the wood was sold in 2009. output being a combination of the factors of production. their total expenditure or by measuring the total output. the value added is the selling price of the furniture minus the cost of the raw material the wood. the value of the input is not included also. Economic activity can be assessed by measuring the total income of households in a country. government and by the foreign sector on domestic goods and services. the circular flow model can be used to show the three approaches to measuring economic activity. this is the value added amount. the output value is ¼10k for that year.. In keeping with the basic model¶s assumption that all households expend the total of their income. Although there may be slight differences between the sum of each measurement this will be due to measurement errors. firms. It is not a measurement of the total value of all items produced as this may lead to double counting. (Turley et al. The total of national income is the sum of all individual¶s income. in turn measuring the total income. If both the sale of the original wood and processed furniture were sold in the same period then the output value would be ¼20k. p.. a logging company may sell a shipment of wood for ¼10k to a furniture company that use the wood to make furniture and sell this furniture at ¼20k. In this simplified case. Government agencies use this data for the purpose of income tax assessment. double counting would occur if both sales prices where included in the output value. .

It measures both the total income and the total expenditure of an economy. Measuring the total incomes. an injection may then take place. it can give a measurement of both as their total value will be the same. can be measured by the cost of running the service as the cost of input is assumed to equal the output.This method for measuring economic activity is referred to as GDP or Gross Domestic Product. . ³GDP is the market value of all final good and services produced within a country in a given period of time. displaying the different transactions between households. If either withdrawals or injections exceed one another. outputs or expenditure of an economy is vital for economic planning. The circular flow can also be used to show how economic activity can be measured. firms. then the economy is unbalanced and will either grow or shrink.´ (Mankiw. Services such as public services that have no nominal output that can be measured. 2009. p328) However GDP cannot measure the market value of every single good or service as some are sold on the black economy. and that this series of withdrawals and injections is how money is circulated. and in ensuring the prosperity of an economy. The circular flow model depicts the flow of money within the economy. For such goods and services that cannot be measured economic statisticians try to estimate their value and add that to their calculations. It describes how as one monetary withdrawal is made. financial institutions. government and trade with other economy.

Turley. .References: Mankiw. Dublin: Gill & MacMillan Ltd. (2006). & O¶Toole. M. Sloman. T.. J. G. Principles of Economics: An Irish Textbook.. (2009) Principles of Economics. (2003) Economics. Maloney. US: South Western Cengage Learning. UK: Pearson Education Limited. G.

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