Answer to Question #123175 in Microeconomics for neereshnee

Question

Consider the hypothetical example of Dominion Island that has firms producing only two goods, gold and cotton, the proceeds of which it uses to purchase other goods and services from neighbouring islands through its banks. Assuming that all other required institutions in an economy are prevalent in this island, discuss the circular flow of income and spending in Dominion Island. No diagram is required.

Answer 1

The circular flow of income and spending shows connections between different sectors of an economy

It shows flows of goods and services and factors of production between firms and households

The circular flow shows how national income or Gross Domestic Product is calculated

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

1.Put aside for future spending, i.e. savings (X) in banks accounts and other types of deposit

2.Paid to the government in taxation (Y) e.g. income tax and national insurance

3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology

The government, i.e. government expenditure (G) e.g. on the NHS or defence

Overseas consumers buying UK goods and service, i.e. UK export expenditure (Y)

An economy is in equilibrium when the rate of injections is equal to the rate of withdrawals from the circular flow.