The circular flow of income model is a theoretical representation of the economy. It shows the distribution of income within the economy and the interaction between the different sectors in a modern market economy. The five-sector model is a more elaborate model in comparison to the basic, two, three and four sector models. The model represents an economy like Australia and divides the economy into five main sectors.
The first sector in the model is the Households sector. This sector refers to all individual members in the economy. All individuals of an economy are consumers. Consumers are concerned with earning an income for themselves and spending on goods and services. Households supply factors of production i.e. land, labour, capital and enterprise and are rewarded with income in the form of rent, wages, interest or profit by the firms sector.
The second sector in the model is the Firms sector. This sector represents all of the business firms involved with the production and distribution of goods and services.
Firms contribute to the circular flow as it is in a business's best interest to obtain factors of production and use them to produce and sell goods and services.
The basic model is based on the assumption that the economy consists of only the Households and Firms sectors. Here, the model is overly and rather, unrealistically simplified so the consideration of the other sectors is absent. In this model, leakages and injections do not exist. It does not take into account the capital market, where savings by consumers and investment by firms are leakages and injections respectively. It also assumes that there is no government sector influencing the economy, meaning consumers pay no taxes as businesses do not receive any benefits nor do consumers receive any social security payments. The basic model also...
In the textbook, there are two circular flow diagrams. One represents the flows in the macro-economy as a closed system and the other represents the flows as an open system. The circular flow diagrams show how money travels through the economic systems including businesses, households, foreign agents and governments (Editorial Board, 2013). Within the closed and open systems there are two consumers. The first consumers are households that buy goods and services and the second consumers are those businesses that purchase factors to produce. Households enter the goods market while the businesses enter factor markets.
The first type of circular flow is that of the closed macro-economy system. This is the circular flow of money. A closed system is an economic model that counts only domestic exchanges but not the foreign agents. This therefore means that without foreign agents, the government or the economy is free of leakages. This system is basically shut off from surrounding environments and is self-contained. An example of a closed system would be the Earth system as a whole. Although energy passes across the Earth’s system boundary, no mass is exchanged throughout the Earth’s system and the rest of the universe (Ritter, M., 2011).
The second type of circular flow in the macro-economy is considered the open system. The open system is the opposite of the closed system. It is an economic model that counts goods and services exchanged domestically and between nations (Editorial Board, 2013). In the diagram in the textbook, it indicates the circular flow of money in an open economy system. Open systems allow energy and mass to pass through and across the system boundary. An example of an open system would be the ocean. The ocean is considered an open system because it allows energy and mass to pass through. Energy which is solar radiation, latent heat and mass including water vapor and precipitation all pass across the boundary between the atmosphere and hydrosphere of the ocean.
In the closed system, households spend their money not only on domestic products but also on goods and services. While looking over the diagram should in the textbook, the inner flow of the closed system includes land, labor, and capital given to businesses from households to receive goods and services to the household. Households use the income (wages and salaries) for services offered to business to purchase goods and services from other businesses. On the other hand, businesses use the money received from households to buy factors of production they require. Thus, money flows in a circular motion within the economy. Therefore, the outer flows of a closed system include money from the household to business in order to pay for wages and rent for the houses.
In the open system, there are more flow levels to consider. An open system considers the flow of money both domestically and internationally between countries. This system includes the government, households, and businesses. The demand for imports from a foreign economy consists of goods for investment, consumption of government goods. The government however enters the factor market as well as the goods market. It enters the factor market in order to obtain domestic labor, capital, and other factors of production to provide goods and services. The government enters the goods market to purchase these goods and services such as cars, trucks, pens or pencils. After the government lends out public services to the household and businesses, the households sends labor, land and capital to businesses and receive goods and services from those businesses as they pay taxes to the government. The next level flow which is the outer flow consists of money sent from the household to the businesses for wages and rent to be paid for the household.
Leakages are taxes, savings, and import expenditures not spend in the economy. There are several leaks in the open system which includes leaks from households to companies, businesses to owners of factors of production and from both households and businesses to the government. Money leakages are created when an American consumer buys imports or when a company in the
United States hires someone from India to work as a customer service representative. The households leaks when consumers buy goods and services from foreign businesses, and the money those households save whether in checking accounts or stocking. The business leaks when firms use labor, capital and other resources from foreign households. These leaks then inject money into the system.
Injection is considered as things that enter into the households or businesses due to the leaks that were caused in the open system. An injection that comes into the household is that of foreign firms sending wages and rent to US households. An injection that comes into the businesses is that of foreign households purchasing goods produced by US firms. An example of a leakage would be a household buying a foreign car from a foreign company outside the United States. An example of an injection would be households in japan purchasing pens and pencils from firms in the United States.
The difference between closed systems and open systems can be defined easily. Getting a better understanding of the two systems and how they work can help us operate throughout our daily lives and the world around us. As we grow we continue to learn about our economy and how the government interacts with households and companies.
Editorial Board (2013). Introduction to Macroeconomics. Web retrieved from http://wow.coursesmart.com/9781934920541/firstsection#X2ludGVybmFsX0J2ZGVwRmxhc2hSZWFkZXI/eG1saWQ9OTc4MTkzNDkyMDU0MS8zMA== Ritter, Michael E. The Physical Environment: an Introduction to Physical Geography. http://www4.uwsp.edu/geo/faculty/ritter/geog101/textbook/earth_system/types_of_systems.html