Chapter 16: Introduction to the Circular Flow of Income

Chapter 16 Introduction to the circular flow of income The simplest model of the circular flow of income Open economy: takes part in international trade. Closed economy: does not export or import goods and services. No economy is a totally closed economy but such an economy can be used in a model of how an economy works. The circular flow in a closed economy and an open economy The impact of injections and leakages 1 Equilibrium and disequilibrium income A closed economy without a government. Such an economy has only two sectors: households and firms. 1. A rise in investment will cause a rise in GDP. The higher investment results in an increase in production, income and spending. 2. In contrast, an increase in saving will mean that some products will be unsold and so production will fall. Draw the diagram. 2 An opened economy with a government. The four sectors are households, firms, the government and the international economy. investment (I) + government spending (G) + exports (X) = saving (S) + taxation (T) + imports (M) 1. More tax revenue collected from households and firms will reduce the amounts they have available for spending. 2. A rise in saving or imports will also cause GDP to fall, at least in the short run. Draw the diagram. 3. A rise in government spending or exports will cause GDP to increase, at least in the short run. Draw the diagram. 3 Part A 1. The extent to which economies trade with other countries varies. For example, Singapore is a very open economy. It has the highest international trade-to-GDP ratio in the world. In contrast, Burundi, a landlocked African country, is a more closed economy. It exports only 5% of its output but imports 25% of the products it consumes (1) How open is your economy? (2) Explain how an economy opening up to international trade may affect its circular flow of income. 2. Complete the table. Closed economy without a government Closed economy with a government Econom ic agents Injectio ns Leakag es 4 Open economy with a government Part B 1. Which combination of changes would increase GDP? 2. What is meant by leakages from the circular flow of income? A. income that is spent on capital goods rather than on consumer goods B. income that is not spent on domestically produced goods and services C. products that are produced by the government D. products that are sold to other countries 3. Which of the following is not an injection into the circular flow? A. exports B. government spending C. imports D.investment 4. What is a leakage from the circular flow of Mauritius? A. income earned by Mauritian firms for selling goods and services to Mauritian consumers B. income earned by Mauritian people working for Chinese multinational companies producing in Mauritius C. spending by the government of Mauritius on computers for the country’s schools D. spending by Mauritian firms on capital goods from France 5. An economy is in equilibrium with a GDP of $520bn. Its exports are $60bn, government spending $90bn, imports $50bn, saving $65bn and taxation $75bn. What is the value of investment? A. $30bn B. $40bn C. $180bn D. $330bn 6. Who buys goods and services in an open economy? A. Households B. households and firms C. households, firms and the government D. households, firms, the government and foreigners 7. Which is a combination of two flows from households to firms? A. factor payments and products B. factor payments and spending on products C. factor services and products D. factor services and spending on products 5 8. Which of the following changes would increase the income flowing round the Sri Lankan economy? A. a decrease in spending by Sri Lankan firms on capital goods B. a decrease in the tax the Sri Lankan government imposes on income C. an increase in goods Sri Lankan firms buy from India D. an increase in saving by Sri Lankan households 9. When is an open economy in equilibrium? A. when investment equals saving B. when investment plus exports equals saving plus imports C. when investment plus government spending equals saving plus taxation D. when investment plus government spending plus exports equals saving plus taxation plus imports 6