UNIT 6 THE CIRCULAR FLOW OF INCOME - IB ECONOMICS



4 SECTOR CIRCULAR FLOW MODEL

Flow 4 Goods and Services

Flow 2 Money income

Flow 1 Factors of Production Flow 3 AE

Private Consumption Spending ( C )

Financial

Sector

Government

Sector

Overseas

Sector

Leakages = S + T + M Injections = I + G + X

THE 4 SECTOR CIRCULAR FLOW MODEL can be used to analyse the factors that contribute to Australia’s economic growth. Like all models, this is a simplification of the real thing, but it helps us to understand how different parts of the Australian economy interrelate.

1. Household sector

• They own, supply or sell the factors of production (resources)

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• They demand or buy final goods and services i.e. Consumers

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2. Business sector

• They purchase or demand resources and pay rent, wages and profits

• They supply or sell final goods and services to consumers/household

3. Financial sector

• Specialise in financial services and act as intermediaries between lenders (savers) and borrowers. E.g. Banks, credit unions, building societies, finance companies, stock exchange etc.

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4. Government sector

• Includes all sectors of government – local, state and federal.

• Collects taxes and uses it on G spending (both consumption (G1) and investment(G2))

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5. Overseas sector

• Trade or financial transactions with rest of the world and our economy. ie Exports and imports in the Balance of Payments

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FLOWS IN THE 4 SECTOR MODEL

Flow 1: Is the supply of resources from households to businesses.

e.g. Land, Labour, capital and enterprise

Flow 2: Gross National Income

Is the payment of Incomes to Households for supplying resources to businesses.

e.g. rent for land, wages for labour and profit for capital and enterprise

Flow 3: Aggregate Expenditure (AE)

The total annual spending on Australian made goods and services. It consists of expenditure from various sources:

▪ Private consumption spending by households (C),

▪ Private investment spending by businesses (I),

▪ Consumption and Investment spending by Government (G) and

▪ Net overseas expenditure made up of spending on our Exports (X) minus our spending on Imports (M)

AE = C + I + G + X - M

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Flow 4: Gross Domestic Product (GDP)

This is the total annual market value of Australia’s production of final goods and services.

Leakages

Leakages are withdrawals of spending from the economy. It occurs when income is not spent on consuming Australian products. It includes:

▪ Savings deposited with Banks or other Financial Institutions (S)

▪ Taxes (T), &

▪ Spending on imported goods and services (M)

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Injections

Injections are additions to the spending on Australian products. They include:

▪ Private Investment (I)

▪ Government Spending (G)

▪ Export Spending (X)

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What happens to economics activity if leakages are greater than injections?

• Output will fall as businesses realise that AE is less than the total production and therefore, unplanned inventory investment is occurring.

o Output is reduced to stop the build-up of unsold stock.

o Fewer factors of production are required by business.

o Household incomes falls.

o Decrease consumption, decrease taxation, decrease imports – increase unemployment

What happens to economic activity if injections are greater than leakages?

• Output will increase as business realises that AE is greater than total production and thus, unplanned inventory disinvestment is occurring (ie stock is being used up).ie

o Increase output

o Increase demand for factors of production

o Increase income

o Increase consumption, increase taxation, increase imports, therefore, decreases in unemployment

Note: a change in output or income is not instantaneous, as it can take time for income to change.

CIRCULAR FLOW OF INCOME MODEL

Fill in the following:

LEAKAGES INJECTIONS

WHO ARE WE? Explain!

|HOUSEHOLD SECTOR | |

|BUSINESS SECTOR | |

|FINANCIAL SECTOR | |

|GOVERNMENT SECTOR | |

|OVERSEAS SECTOR | |

• SAVINGS (S) + TAXATION (T) + IMPORTS (M) = LEAKAGES

• INVESTMENT (I) + GOV’T SPENDING (G) + EXPORTS (X) = INJECTIONS

IF

LEAKAGES > INJECTIONS Speed ↓+ Rate of EconomicGrowth/income/production ↓

LEAKAGES=INJECTIONS Steady Speed = No change in EconomicGrowth/income/production

LEAKAGES ................
................

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