Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Therefore, the functions of households and firms are reversed in factor markets as compared to in goods and services markets. By using its budget therefore the government can influence the levels of income, output and expenditure for the economy as a whole. The Circular Flow in a Two-Sector Economy: In a simplified economy with only two types of economic agents, households or consumers and business firms, the circular flow of economic activity is shown in Figure 10.
As long as leakages are equal to injections, the circular flow of income continues indefinitely. Basis of Flow of Funds Accounts: The circular flow helps in calculating national income on the basis of the flow of funds accounts. We further assume that there are no inter-households borrowings. However, an eminent British economist J. Monetary flow illustrates that, in terms of money, factor rent, wage, interest and profit flows from the business sector to household sector. However, it cannot be ignored that the economy intrinsically requires and the creation of waste that must be absorbed in some manner. Consumption and production are flows which operate simultaneously and are interrelated and interdependent.
The locked room analogy illustrates a man who is making a choice to either stay or leave the room. There is no saving S. Government borrowing increases the demand for credit which causes rate of interest to rise. This type of economy is self sufficient. Five Sector Model This article may contain original research.
The foreign sector influences how services move between firms and households. We can know whether the economy is working efficiently or whether there is any disturbance in its smooth functioning. We assume that all the savings of households come in the financial market. It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. In case of cash deficit, the government borrows from the capital market to maintain a balance in the economy.
Households then get a return on their financial capital in the form of stock dividends, bond payments, and the like, just as households get a return on their labor in the form of wages. But if S + T + M I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. Principles of Economics, 6th edition. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and import goods and services. Things are worked out within. For all exports of goods, the government receives payments from abroad. The circular flow of income in four sector economy can be explained by the flowing diagram: From the viewpoint of the circular flow of income, each sector has dual roles to play in the economy; while a sector receives certain payments from other sectors, it pays back to those sectors as well.
Saving-Investment Identity in National Income Accounts in a Two Sector Economy : Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade. In this country most property belongs to the state, the government controls almost every part of the economy sets production levels , the state directs all significant economic activity, is regulated heavily by the states control, financial sector is controlled by the state, and formal trade is minimal mainly with China and South Korea North Korea, 2013. This can be represented by the money flow from the financial market to the Government and is labelled as Government borrowing To avoid confusion we have not drawn this money flow from financial market to the Government. In addition to the household sector that spends C goods and the business sector that produces the goods, two sectors that are also included in the circular flow of income include the government sector and the foreign sector. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. Monetary Policy involves changes in the base rate of interest to influence the rate of growth of aggregate demand, the money supply and ultimately price inflation.
When foreigners buy goods and services produced by domestic firms, they are exports in the circular flow of income. It can the be further defined to include two flows, one, a flow of goods and services and the other, a flow of money. The level of income in an economy depends on the level of pending in that economy. Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction. The flow diagram demonstrates that when one sector is at risk it puts economic market conditions in jeopardy because they are all reliant upon one another. In other words, production is a means beginning and consumption is the end of all economic activities.
They also receive royalties, interests, dividends, profits, etc. These exports and imports in the circular flow are shown in Figure 12. We further assume that the government does not play any part in the national economy. These materials and energy are used by households and firms a like to create products and wealth. Money is also added to the circular flow through X which involves foreign entities purchasing goods from the economy. Circular Income Flow with Saving and Investment : In our above analysis of the circular flow of income we have assumed that all income which the households receive, they spend it on consumer goods and services. It sets standards for weights and measures, and the monetary system.
The capital market refers to a number of financial institutions such as commercial banks, savings banks, loan institutions, the stock and bond markets, etc. A close example of a closed system would be North Korea. In other words, the flow of money income will not always continue at a constant level. On the other hand if value of imports exceeds value of exports of a country, trade deficit occurs. The model of the economy demonstrates that it literally works as a flow or a cycle.