Question

Describe with the help of a diagram various flows of money in a closed economy. 

With the help of a well-labelled diagram, show the circular flow of income in a three-sector model.

Answer 1

An economy that does not trade internationally, meaning that neither imports nor exports occur, is said to be closed. The three sectors in the closed economy model are as follows:

• Households
• Firms (Producers)
• Government

Types of flows of money in a closed economy:

1. From firms to households: In exchange for factor services, businesses give households factor incomes, such as wages, rent, interest, and profit.
2. From households to firms: Consumption expenditure is the term used to describe how households utilize their income to purchase goods and services made by businesses.
3. From households and firms to government: Taxes are a leakage from the circular flow that are paid by both households and businesses to the government.
4. From government to households and firms: The government buys goods and services from businesses and makes transfer payments (such as pensions and subsidies).
5. From households to capital market: Another leakage from households to the capital market is the saving of a portion of family income.
6. From capital market to firms: Businesses use these savings as an injection of capital for manufacturing. 

For the circular flow to remain in equilibrium:

S + T = I + G

where:

• S = Savings
• T = Taxes
• I = Investment
• G = Government spending

Money moves constantly between families, businesses, the capital market, and the government in a closed economy. When total injections (I + G) equal total leakages (S + T), the economy is still in balance.