If it did not trade outside of itself, we would call it a 2-sector, closed economy. In other words, saving is withdrawal of some money from the income flow. Figure 2 shows that the equality between saving and investment comes about through the credit or capital market. To explain this we have to introduce saving and investment in the analysis of circular flow of income. When the entire diagram is created, it shows the money, which comes from individuals or households through purchases and factors, become the income of the businesses. Unfortunately, the statistics upon which the most important conclusions concerning this subject must be based are not at hand and are not likely to be for a long time to come.
So long as the household sector continues spending the entire income in purchasing the goods and services from the business sector, there will be a circular flow of income and production. Savings are coded as ' S'. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. To measure aggregate demand in a closed economy, we simply add consumption spending C , investment spending I and government spending G. Note that all Government expenditure is here treated as consumption expenditure.
Production equals sales or supply equals demand, and the economy will continue to operate at this level in a circular flow of money. Inflationary and Deflationary Tendencies: Leakages or injections in the circular flow disturb the smooth functioning of the economy. They also offer incomes to the households. Businesses that invest I money to purchase capital stocks contribute to the flow of income in the economy. The household then uses the income to purchase goods and services from firms. On the other hand, some firms make and sell exports overseas, and others borrow money and invest it in their firms in the form of capital goods. One of the most important is called the The money flows among the different sectors of an economy as individuals and firms buy and sell goods and services.
The households supply saving to the capital market and the firms, in turn, obtain investment funds from the capital market. Firms are legal entities, not people. Households sell their factor services to firms in the factor markets and in exchange receive wages the left hand side of the flow. It shows exactly the same flows, but represents them a little differently. This topic is called 'Aggregate demand and supply. When discussing the supply and demand for a good or service, it is appropriate for households to be on the demand side and firms to be on the supply side, but the opposite is true when modeling the supply and demand for labor or another factor of production.
Still, the circular flow still teaches us something very important. The circular flow of income and production operates at the same level and tends to perpetuate itself. The circular flow in a two-sector economy is depicted in Figure 1 where the flow of money as income payments from the business sector to the household sector is shown in the form of an arrow in the lower portion of the diagram. Much of the data you will come across in your course is often presented in the form of index numbers and index series. . It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services. Firms use these factors to produce the goods that households use their income to purchase.
These are coded ' X' for exports and ' I' for investment and are called injections as the money returns into the circular flows. Paid to the government in taxation T e. It also receives royalties, interest, dividends etc. This simplistic model suggests the old economic adage that supply creates its own demand. Over time, repeated government borrowing adds to the domestic debt.
The business sector generates its revenue by selling goods and services to the household sector. Factors of production flow form households red arrow to firms, so they can produce more goods and services. The method through which national income statistics is prepared and compiled is called national income accounting. Through investment, the equilibrium level between income and output is maintained at the original level. You also report that there was a recent increase in the price level. The government finances its deficit by borrowing from the capital market which receives funds from household sector in the form of saving. The circular flow of income is a good place to start.
If government purchases exceed net taxes then the government will incur a deficit equal to the difference between the two, i. In fact, the household and business sectors do not spend their entire money income. These funds flow from households to firms every time people invest in companies via stocks, bonds, or other forms of investment. Therefore, the spending goes back to firms. Therefore, injections are investment, government spending and exports.
Two-sector economy is a hypothetical economy, whereas the three-sector economy is much more realistic. For example, firms have to pay workers to produce the output. In goods and services markets, households buy finished products from firms that are looking to what they make. This ownership is achieved through many forms, ranging from firms that are owned and operated by individuals to giant corporations whose ownership is determined by stock holdings. Above all, national income figures enable us to compare standards of living of different countries.