1. Circular Flow of Income

Question 1

What do households provide firms and what do they receive in return?

Answer 1

Households provide firms with capital, entrepreneurship, land and labour. Firms pay for these services with interest, profits, rent and wages respectively (total income of the country).

Question 2

At equilibrium in a 2-sector economy, what is the relationship between the income earned by households and consumption expenditure made by them.

Answer 2

At equilibrium, it is assumed that all the income earned by households is spent as consumption expenditure on goods produced by firms, (firm’s revenue).

Question 3

What are the four sectors of an economy?

Answer 3

The four sectors of an economy are households, firms, government and the foreign sector.

Question 4

What are the various injections and withdrawals and who do they go to?

Answer 4

J = I (Financial markets) + G (Government) + X (Foreign sector)
W = T (Government) + S (Financial markets) + M (Foreign sector)

Question 5

Define the various withdrawals.

Answer 5

Savings is income that households choose not to spend but to put aside for the future.
- Savings are normally deposited in financial institutions such as banks.

Taxes are compulsory payments to the government that is levied on individuals and entities.
- Taxes such as personal income tax are paid out of household incomes, and corporate taxes are paid out of firms’ incomes. In the circular flow model, taxes are shown to be leaving the circular flow from just one point - households.

Import expenditure is expenditure on goods and services that are produced by other countries or on goods and services using components that are produced by other countries.

Question 6

Define the various injections.

Answer 6

Investment is the act of acquiring new fixed capital assets like buildings, plants, equipment and machineries by firms, as well as the accumulation of stocks and inventories such as raw materials, semi-finished goods and finished goods held by firms.

Government expenditure is expenditure by the government on goods and services produced by firms.
- It include spending on roads, hospitals and schools.

Export expenditure is expenditure by foreign buyers on goods and services produced by firms domestically.

Question 7

When is the equilibrium level of RNY attained?

Answer 7

The equilibrium level is reached where there is no tendency for national income to change as firms have no incentive to increase or reduce production in the next time period when there is no accumulation/rundown of inventories.

Question 8

What are the three main features at the equilibrium level of national income?

Answer 8

1. Total spending by the 4 sectors of the economy = total income earned by the FOPs.
   
   • If total spending > total income, the economy will expand i.e. an increase in real GDP (and vice versa)
2. All goods and services produced by firms are bought up by different sector of the economy.
   
   • If firms produce more goods and services than what is bought up, there will be an accumulation of inventories which will cause firms to reduce production in the next time period, and hence the economy wil contract in the next time period (and vice versa)
3. W = J
   
   • If J > W, national income will rise (and vice versa)