Describe the circular flow of income for an open economy with
Government. Use the circular flow to demonstrate three different
ways of measuring economic activity.
The circular flow of economics shows the movement of resources between
consumers and producers. A more complete open circular flow model also shows the
interaction between financial institutions, foreign markets and the government and the
economy. It is of great importance for governments, firms and households to have an
accurate measurement of the economy to aid financial decisions such as whether or
not to invest money. The circular flow model can also be used to show the three
different ways of measuring economic activity.
At its most basic the circular flow model, shown on the right, displays the
relationship between households and firms. The households supply the factors for
production to the firms, they supply the labour, land and capital that firms use to
produce goods and services. These factors of production are also referred to as inputs.
(Turley et al., 2006) In return for these factors of production the households receive an
income, paid in the form of wages, rent or dividends. Households use their incomes to
purchase the goods and services supplied by firms, this is known as consumer
expenditure. From the diagram we can see how these repeating exchanges result in a
circular flow of economic activity. The outer circle shows us the flow of goods and
services, and of factors for production. Macroeconomics is concerned with the inner
circle, the monetary flow of incomes and of expenditures.
The basic circular flow model however is too simplistic to be an accurate
representation of a country’s economy. To give a more accurate representation, the
circular flow model must incorporate three more elements, namely financial
institutions, foreign markets and the government. The basic model acts on the
assumption that households expend the total amount of their incomes, in reality a
household may choose to put some of their income into savings. (Turley et al., 2006)
Financial institutions such as banks facilitate these savings. In this regard financial
institutions make a monetary withdrawal from the economy, however they also make
an monetary injection into the economy in the form of investments. The term
investment, refers to corporate or business expenditure and the inventory build up of
raw materials and finished goods. (Turley et al., 2006) Firms finance investment
expenditure by borrowing funds from the financial institutions that facilitate
household savings.
Diagram of an open circular flow model with government.
The government also plays a role in the economy. It invests vast amounts of
money in services such as health care, education and law enforcement. To fund this
the government implements taxes, primarily in the form of two categories, income tax
on households and tax on expenditures such as VAT. (Turley et al., 2006) These taxes
take money from the economy but then the money may be injected back into the
economy by means of the investments they fund. The government also funds social
welfare from taxes, this is an example of a transfer payment, where wealth is simply
redistributed from one household to another rather then being used for a particular
investment or service.
A closed economy is one that does not trade with other economies markets,
open economies alternatively do trade with foreign markets in the form of imports and
exports. Imports refer to foreign goods and services that are purchased by domestic
households and firms, while exports refer to domestic goods and services purchased
by foreign households and firms. In this respect imports cause a monetary withdrawal
from the economy and exports result in an injection into the economy. The difference
between imports and exports is known as net exports. If the value of exports exceed
imports the value is positive, whilst the value is negative if the value of imports
exceeds the value of exports.
The circular flow model shows that there are three forms of withdrawals, or
leakages in the economy, savings, taxes and expenditure on imports. There are also
three forms of injections, investment, government expenditure and exports. (Sloman,
2003) When the total amount of withdrawal equals injection, the economy is said to
be in a state of equilibrium. If there is an excess of injections over withdrawals there
is economic growth, resulting in greater output and a drop in unemployment. The
reverse occurs when withdrawals exceed injections, the economy shrinks and there is
a drop in outputs and an increase in unemployment.
As well as being a representation of a country’s economy, the circular flow
model can be used to show the three approaches to measuring economic activity, as
shown on the right. Economic activity can be assessed by measuring the total income
of households in a country, their total expenditure or by measuring the total output,
output being a combination of the factors of production. In keeping with the basic
model’s assumption that all households expend the total of their income, in turn
measuring the total income, expenditure or output of a country should result in the
same numeric total for each measure. Although there may be slight differences
between the sum of each measurement this will be due to measurement errors. (Turley
et al., 2006)
National output is the sum of the value added of production from the economy.
It is not a measurement of the total value of all items produced as this may lead to
double counting. “Double counting occurs if the expenditure on intermediate goods is
included in the calculation of nation output.” (Turley et al., 2006. p.307) For example,
a logging company may sell a shipment of wood for €10k to a furniture company that
use the wood to make furniture and sell this furniture at €20k, double counting would
occur if both sales prices where included in the output value. If both the sale of the
original wood and processed furniture were sold in the same period then the output
value would be €20k. However if the wood was sold in 2009, the output value is €10k
for that year. Then if the furniture goes on to be sold in 2010 the output would be
valued at €10k also, this is the value added amount. In this simplified case, the value
added is the selling price of the furniture minus the cost of the raw material the wood.
This approach ensures that when measuring an output, the value of the input is not
included also.
In Ireland the most common measurements of economic activity are national
income and expenditure, and is published annually by the Central Statistics Office
entitled National Income and Expenditure. National expenditure is the total of all
expenditure by households, firms, government and by the foreign sector on domestic
goods and services. The total of national income is the sum of all individual’s income,
the profit of companies and from rented dwellings. Government agencies use this data
for the purpose of income tax assessment.
This method for measuring economic activity is referred to as GDP or Gross
Domestic Product. It measures both the total income and the total expenditure of an
economy, it can give a measurement of both as their total value will be the same.
“GDP is the market value of all final good and services produced within a country in a
given period of time.” (Mankiw, 2009, p328) However GDP cannot measure the
market value of every single good or service as some are sold on the black economy.
For such goods and services that cannot be measured economic statisticians try to
estimate their value and add that to their calculations. Services such as public services
that have no nominal output that can be measured, can be measured by the cost of
running the service as the cost of input is assumed to equal the output.
The circular flow model depicts the flow of money within the economy,
displaying the different transactions between households, firms, financial institutions,
government and trade with other economy. It describes how as one monetary
withdrawal is made, an injection may then take place, and that this series of
withdrawals and injections is how money is circulated. If either withdrawals or
injections exceed one another, then the economy is unbalanced and will either grow or
shrink. The circular flow can also be used to show how economic activity can be
measured. Measuring the total incomes, outputs or expenditure of an economy is vital
for economic planning, and in ensuring the prosperity of an economy.
References:
Mankiw, G. (2009) Principles of Economics. US: South Western Cengage Learning.
Sloman, J. (2003) Economics. UK: Pearson Education Limited.
Turley, G., Maloney, M., & O’Toole, T. (2006). Principles of Economics: An Irish
Textbook. Dublin: Gill & MacMillan Ltd.
