Question

GRAPH MAP Please complete and label this circular flow model. Do your best not to refer to the book or notes. 1. What arrow goes into households? What are the three primary expenditures of households shown in the model? 2. What arrows go into firms? What are the three primary expenditures of firms shown in the model? 3. What arrows go into government? What is the only expenditure of government shown in the model? 4. What are the four arrows going into the outputs market?

Answer 1

Circular Flow of Income

Circular Flow of income is a graphical representation of the movement of money in the economy. It demonstrates the equivalence between the “Money Withdrawal” and “Money Injections” in the economy.

o Money is injected in an economy in the form of Investment (I), Government Spending (G) and Exports (X)

o Money is withdrawn in an economy in the form of leakages such as Savings(S), Taxation (T) and Imports (M)

The below diagram shows a circular flow of income in case of a four sector economy or an open economy.

1. The House-hold sector supplies factor of production to the factor market and in return it receives personal income as a part of factor payments from the firms. Thus, arrow AB goes into the Households.

Arrow AB – Personal Income

The 3 primary expenditures by households shown in the model are:

(a) Taxes : Household pays taxes to the government shown by Arrow - CD

(b) Consumption Expenditure – With disposable income i.e. personal income after paying taxes, the HH spend on purchasing domestically produced goods and services from the output market, which is shown by Arrow - EG

(c) Imports – Under a 4 sector model, the households purchases goods and services from abroad in the form of Imports, which is shown by arrow EF

2. Firms make investment expenditure in the output market. The revenue earned in the product market (by sales of goods and services) flows into the Firms as “Expenditure on Domestic Product”. Thus, arrow HI goes in to the Firms/Business Sector.

Arrow HI – Personal Income

The 3 primary expenditures by Firms shown in the model are:

(a) Investment Expenditure: The amount which firm invest to produce goods and services that are sold in the output market, which is shown by arrow JK

(b) Taxes : Firms too pay taxes to the government shown by Arrow - LM

(c) Factor Payments : Firms hire factor of production from households in the form of labor, land, capital, etc, in return of which it pays them factor payments, which is shown by arrow NO

3. Government receives taxes from both Firms and Households which are represented by the arrows LM and CD respectively. The government also borrows from the financial market, lets say in order finance the deficit or to invest on public goods projects such as infrastructure, telecommunication, railways, etc. This is shown by arrow PQ.

The only expenditure made by the government are the government purchases from the output market, which is shown by the arrows RS.

4. The four arrows going into the output market are the 4 types of expenditure made by the four sectors in the economy:

Arrow JK – Investment Expenditure by Firms

Arrow RS – Government Purchases by the Government Sector

Arrow EG – Consumption Expenditure by the Households

Arrow TU – Expenditure on domestically produced goods by the foreign sector, which are the exports.

REST OF THE WORLD OUTPUT MARKET EXPORT SS FOREIGN SECTOR EXPENDITORE ON DOMESTIC PRODUCT GOVERNMENT PURCHALES INVESTMENT EXPENDITUFE CONSUMPTION EXPENDITURE IMPORTS F I GOVERNMENTA C TAXES TAXES (FIRMS GOVERNMENT BORROWING HOUSE HOLDS P FINANCIAL MARKET FACTOR PAYMENT PERSONAL INCOME FACTOR MARKET