1/1/2024 0 Comments Circular flow modelOn the other hand, taxes on business firms tend to reduce their investment and production. Reduced consumption, in turn, reduces the sales and incomes of the firms. It tends to reduce consumption and saving of the household sector. As already noted, taxation is a leakage from the circular flow. Now we take the household, business and government sectors together to show their inflows and outflows in the circular flow. These government expenditures are injections into the circular flow. On the other hand, the government purchases all its requirements of goods of all types from the business sector, gives subsidies and makes transfer payments to firms in order to encourage their production. All types of taxes paid by the business sector to the government are leakages from the circular flow. Next take the circular flow between the business sector and the government sector. All such expenditures by the government are injections into the circular flow. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow.īut the government purchases the services of the households, makes transfer payments in the form of old age pensions, unemployment relief, sickness benefit, etc., and also spends on them to provide certain social services like education, health, housing, water, parks and other facilities. Taxation is a leakage from the circular flow and government purchases are injections into the circular flow.įirst, take the circular flow between the household sector and the government sector. For this, we add taxation and government purchases (or expenditure) in our presentation. To this we add the government sector so as to make it a three-sector closed model of circular flow of income and expenditure. So far we have been working on the circular flow of a two-sector model of an economy. Circular Flow in a Three- Sector Closed Economy: The households supply saving to the capital market and the firms, in turn, obtain investment funds from the capital market.ģ. The capital market coordinates the saving and investment activities of the households and the business firms. The capital market refers to a number of financial institutions such as commercial banks, savings banks, loan institutions, the stock and bond markets, etc. In Figure 2 there is a capital or credit market in between saving and investment flows from households to business firms. (ii) indirectly via investment expenditure. (i) Directly via consumption expenditure, and Such leakages are saving, and inflows or injections are investment which equals each other.įigure 2 shows how the circular flow of income and expenditure is altered by the inclusion of saving and investment.Įxpenditure has now two alternative paths from household and product markets: In an economy, “inflows” and “leakages” occur in the expenditure and income flows. The actual economy is not as explained above. Circular Flow with Saving and Investment Added: Goods flow from the business sector to the household sector in the product market, and services flow from the household sector to the business sector in the factor market, as shown in the inner portion of the figure. There are also flows of goods and services in the opposite direction to the money payments flows. Thus payments go around in a circular manner from the business sector to the household sector and from the household sector to the business sector, as shown by arrows in the output portion of the figure. The business sector, in turn, makes payments to the households for the services rendered by the latter to the business-wage payments for labour services, profit for capital supplied, etc. Thus the household sector purchases all goods and services provided by the business sector and makes payments to the latter in lieu of these. In the product market, the household sector purchases goods and services from the business sector while in the factor market the household sector receives income from the former for providing services. The circular flow of income and expenditure in such an economy is shown in Figure 1 where the product market is shown in the upper portion and the factor market in the lower portion. Thus the household sector buys the output of products of the business sector. The business sector consists of producers who produce products and sell them to the household sector or consumers. This sector receives income by selling the services of these factors to the business sector. The household sector owns all the factors of production, that is, land, labour and capital. We begin with a simple hypothetical economy where there are only two sectors, the household and business.
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