Answer to Question #120047 in Economics for Lara

Question

Draw and explain the circular flow of income assuming that the economy is closed and there is the existence of government. What is the effect of adding a foreign sector? (25 marks)

Answer 1

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services between such economic agents as firms, households and the government, which interact in goods and services or factor markets.

The government sector consists of the economic activities of local, state and federal governments. Flows from households and firms to government are in the form of taxes. The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services. Every payment has a corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite direction. As a result, the aggregate expenditure of the economy is identical to its aggregate income, making a circular flow.