Circular Flow Model

Question 1

What is the circular-flow model?

Answer 1

a simplification showing how the economy works and the relationship between income, production and spending in the economy as a whole

Question 2

Difference between an open economy and a closed economy

Answer 2

An open economy shows the working of an economy that is open to foreign trade.
A closed economy excludes the foreign trade sector

Question 3

Households

Answer 3

•a flow of money, goods and services between household sector and business sector
•households are the owners of the services of factors of production and they place their factors of production on the market so it can be bought
•households earn income in the form of wages by selling their factors of production to businesses

Question 4

Business sector

Answer 4

•business use factors of production to produce goods and services on which the households spend their income
•business place goods and services on the product market which is then bought by households to satisfy their needs
•business receives an income

Question 5

State/government in household sector

Answer 5

•there is a flow of money, goods and services between the household sector and state
•household sector provides the state with labour and receive income
•the state provides the household with public goods and services (e.g. parks, hospitals)
•households pay taxes to the state
•this is income for the state

Question 6

State/government in business sector

Answer 6

•there is a flow of money, goods and services between the business sector and state
•business sector provides the state with goods and services for which the state pays
•the state provides the business sector with public goods and services (e.g. roads, electricity, harbours)
•business pays taxes to the state

Question 7

Foreign sector

Answer 7

•there is a flow of goods (imports) to the business sector from the foreign sector
•businesses that import these goods pays for it
•this is regarded as expenditure for the business
•there is also a flow of goods (exports) from the business sector to the foreign sector
•businesses export their goods and services to other countries and earn money for it
•this is income for the business

Question 8

Relationship of the financial sector in the circular flow

Answer 8

•financial sector consists of banks, insurance companies and pension funds
•they act as a link between households and firms who have surplus money and others in the economy who require funds
•money provided by households and firms to the financial sector is known as savings
•business can borrow money and use it to purchase capital goods
•spending on capital by firms is regarded as investment

Question 9

Real flow and money flow

Answer 9

•the transactions that take place on markets
•the exchange process has 2 components:
•real flow: goods, services and factors of production
•money flow: the earning of money (income) and payments that is made

Question 10

Real flow

Answer 10

•consumers render production factors to producers and gov via the factor market
•goods and services are supplied by producers via the product market to gov and consumers
•gov provides public goods and services to consumers and producers
•producers receive goods and services (imports) and deliver goods and services (exports) to the foreign sector

Question 11

Money flow

Answer 11

•consumers earn an income for their production factors via factors market from businesses
•business sector earn an income for goods and services via the product market from gov and consumers
•gov earn an income from consumers and businesses
•businesses earn an income for exports from the foreign sector and make payments to the foreign sector for imports

Question 12

Equations
•Leakages

Answer 12

•a leakage represents the withdrawal of money from the economic cycle (local economy)
•it does not give rise to a further round of income
•domestic purchases on goods and services decrease
•in an open economy, the leakages are taxes (T), the expenditure on imports (M) and savings (S)

Question 13

•Injections

Answer 13

•injections represents the injection of money into the economic cycle (local economy)
•it refers to the flow of any spending which is not derived from income (Y)
•additional money enters the economy and it increases income
•domestic purchases on goods and services increase
•in an open economy, injections are government spending (G), the revenue earned from exports (X) and investment spending (I)

Question 14

•Equilibrium

Answer 14

•the economy is in equilibrium when leakages are equal to injections

Question 15

•Disequilibrium

Answer 15

•the economy is in equilibrium when:
1.leakages are more than injections (L>J)
2.injections are more than leakages (J>L)