The circular flow of income in an open economy, Macroeconomics


The circular flow of income in an open economy 

An open economy is one in which international trade exists. Assume also that there is government spending and taxation.

Thus households need not consume all of their income. Some may be saved (S), spent on imports (M), or taxed (T). So the savings (S) and imports (M) and taxes imposed (T) are known as "withdrawals" (W) or "leakages" from the actual flow. An increase in withdrawals (W) will reduce the level of output and income (Y).

However, Y will be added to investment (I), government spending (G) and money spent by foreigners on exports (X). These are known as "injections" (J).In an open economy the size of Y is determined by the size of AD, which is determined by C + I + G + X. 



1979_The circular flow of income in an open economy.png






Over a period of time there are withdrawals (W) from the income flow. If individuals save, then the income is taken out of the circular flow. If an economy's income is Rs.1,000 and it saves Rs.200, then only Rs.800 is passed on as expenditure. Other withdrawals are taxes and imports. The latter represent a loss of income from the domestic economy to some overseas economy.

Alongside withdrawals there are also injections (J) into the flow of income. These are in the form of investment, government spending and exports, savings withdrawn and used to finance investment, either directly through the purchase of capital goods or indirectly via financial institutions such as banks. Thus, the original withdrawal or savings ends up as an injection elsewhere in the system. Taxes end up as government spending on goods and services. Exports are financed from spending made by other countries. This spending enters into the circular flow as an injection of income.

In this economy

                 Y = AD

Therefore, Y = C + I + G + X

              Y= C + J

Where J equals injections i.e. I, G and X.

For equilibrium we require all withdrawals to equal all injections i.e. W = J. If injections are greater than withdrawals then the level of national income (i.e. total incomes) will rise, and vice versa. 


Posted Date: 9/12/2012 12:49:11 AM | Location : United States

Your posts are moderated
Related Questions
In 2009, ABC Company made $2M of net profit and spent $100,000 on advertisement. In 2010, it made $2.5M of net profit and spent $150,000 of advertisement. Based on this information

what are the advantages and disadvantages of unemployment

The Pigou effect: A) suggests that as prices fall and real money balances rise, consumers should feel less wealthy and spend less. B) suggests that as prices fall and real mo

Your Insurance firm processes claims through its newer, larger high tech facility and its older, smaller low-tech facility. Each month, the high-tech facility handles 10,000 claims

Q. Determination of GDP in the cross model? In the cross model, GDP is determined as the solution to the equation Y D (Y) = Y We may explain

The market for quits is initially competitive and the market demand is: P=400-0.4QD. The Combined marginal costs of the firms in the quit industry are: MC=50+0.6Q. a. Draw the

Compare Classical economic theory to Keynesian economic theory. Which approach, if either is the US currently applying and what have been the effects of such policies?

For which of the following medical goods or services is the income elasticity of demand largest? a. emergency services after a car accident b. measles shots c. physical ex

Maximum profits will occur at the output level where is the greatest vertical distance between Total Revenue(TR) AND Total Cost(TC. uSE THE TOTAL REVENUE-TOTAL COST CURVES TO Illus

A mechanical engineer who is anticipating paying for his daughter's college education plans to start depositing money now (year 0) and continue through year 17. If he deposits $ 50