Circular Income Flow in a Two Sector Economy
Real flows of resources, goods and services have been shown in Fig. 6.1. In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark.
In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits.
In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households.
Thus we see that money flows from business firms to households as factor payments and then it flows from households to firms. Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year. This is how the economy functions. It may, however, be pointed out that this flow of money income will not always remain the same in volume.
In order to make our analysis simple and to explain the central issues involved, we take many assumptions. In the first place, we assume that neither the households save from their incomes, nor the firms save from their profits. We further assume that the government does not play any part in the national economy.
In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households. Thirdly, we assume that the economy neither imports goods and services, nor exports anything. In other words, in our above analysis we have not taken into account the role of foreign trade. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government.
Circular Income Flow in a Three Sector Economy with Government
In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes earned by households. Government affects the economy in a number of ways.
Here we will concentrate on its taxing, spending and borrowing roles. Government purchases goods and services just as households and firms do. Government expenditure takes many forms including spending on capital goods and infrastructure (highways, power, communication), on defence goods, and on education and public health and so on. These add to the money flows which are shown in Fig. 6.3 where a box representing Government has been drawn. 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.
Government expenditure may be financed through taxes, out of assets or by borrowing. The money flow from households and business firms to the government is labelled as tax payments in Fig. 6.3 This money flow includes all the tax payments made by households less transfer payments received from the Government. Transfer payments are treated as negative tax payments.
Another method of financing Government expenditure is borrowing from the financial market. 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). Government borrowing increases the demand for credit which causes rate of interest to rise.
It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. Total expenditure flow in the economy is now the sum of consumption expenditure (denoted by C), investment expenditure (I) and Government expenditure (denoted by G). Thus
Total expenditure (E) = C + I + G …..(i)
Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus
Y = C + S + T … (ii)
Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii) above we have
C + I + G = C + S + T … (iii)
Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have
I + G = S + T …(iv)
By rearranging we obtain
G – T = S – I … (v)
Equation (v) is very significant as it depicts what would be the consequences if government budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue (7), that is, G >T, the government will have a deficit budget. To finance the deficit budget, the Government will borrow from the financial market.
For this purpose, then private investment by business firms must be less than the savings of the households. Thus Government borrowing reduces private investment in the economy. In other words, Government borrowing crowds out private investment.
Money Income Flows in the Four Sector Open Economy
We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Foreigners interact with the domestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. Goods and services produced within the domestic territory which are sold to the foreigners are called exports.
On the other hand, purchases of foreign-made goods and services by domestic households are called imports. Figure 6.4 illustrates additional money flows that occur in the open economy when exports and imports also exist in the economy. 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.
A flow of money spending on imports have been shown to be occurring from the domestic business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money expenditure on exports of a domestic economy has been shown to be taking place from foreign countries to the business firms of the domestic economy.
If exports are equal to the imports, then there exists a balance of trade. Generally, exports and imports are not equal to each other. If value of exports exceeds the value of imports, trade surplus occurs. On the other hand if value of imports exceeds value of exports of a country, trade deficit occurs.
In the open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. These days financial markets around the world have become well integrated.
When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M), net capital inflow will take place. By net capital inflow we mean foreigners will borrow from domestic savers to finance their purchases of domestic exports. In this way as a result of net capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets.
From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net exports, that is, X-M where X represents exports and M represents imports. Imports must be subtracted from the total expenditure on foreign produced goods and services to get the value of net exports. Thus, in the open economy
National Income = C + I + G + NX
where NX represents net exports, X-M.
Since national income can be either consumed, saved or paid as taxes to the Government we have
C + I + G + NX = C + S + T