The Circular Flow Model

Definition and Purpose

• Circular Flow Model: Depiction of the economic exchanges of money and goods.
• Purpose: Demonstrates interactions and interdependencies within the economy related to the movement of income, production, and expenditure.

Differences Between Closed and Open Economies

• Closed Economy:
  • Excludes foreign trade and investment activities.
• Open Economy:
  • Incorporates foreign trade and investments.
• Implications: Open economies are dynamic and interconnected, influencing economic analyses.

Economy Type	Foreign Interactions
Closed Economy	No trade or investment with foreign entities.
Open Economy	Encompasses trade and investment with international entities.

Key Economic Actors

• Households:
  • Definition: Consumers and owners of production factors, including land, labour, and capital.
  • Role: Supply factors of production, such as labour, and receive compensation.
  • Examples: Employees earning salaries, property owners receiving rent.

• Firms:
  • Definition: Producers of goods and services.
  • Utilise production factors to create goods and services.
  • Examples: Manufacturing companies, retail businesses.

• Government:
  • Engages in tax collection and redistribution through services and welfare programmes.

Real and Money Flows

• Real Flows:
  • Tangible outcomes of production activities, such as goods and services.
  • Resources: Flow of labour and capital from households to firms.

• Money Flows:
  • Reflect monetary transactions that facilitate real flows.
  • Example: Firms disbursing wages, households purchasing goods and services.

Understanding the Basic Circular Flow Model

Overview

• Basic Circular Flow Model: Demonstrates economic transactions between key participants: households and firms.

The Circular Flow

• Production and Income Generation:
  • Income streams flow from firms to households as compensation for production factors.
  • Example: Factories pay wages; employees spend earnings on goods.

• Spending and Consumption:
  • Households spend income on goods and services produced by firms, sustaining economic cycles.
  • Example: Employees purchase essentials with salaries.

Introduction to the Foreign Sector's Role in the Model

With globalisation, the foreign sector becomes pivotal in economic models. The transition from closed to open economies is illustrated by countries like China and India, which have leveraged foreign trade for significant economic expansion.

• Exports and Imports:
  • Exports: Domestically produced goods and services sold internationally, contributing to GDP as injections.
  • Imports: Goods and services acquired from abroad for domestic use, reducing GDP as leakages.

Comparing Exports and Imports	Exports	Imports
Definition	Sold internationally	Acquired domestically
Economic Role	Injections	Leakages

Key Concepts: Leakages and Injections

Leakages and Injections are fundamental for comprehending the circular flow in an open economy.

• Leakages: Non-consumption uses such as savings, taxes, and imports.
• Injections: External contributions like investments, government expenditure, and exports.

The Dynamics of Exports and Imports

• Exports as Injections:

  • Multiplier Effect: Amplifies activity benefiting multiple sectors, fostering further economic expansion.

• Imports as Leakages:

  • Excessive reliance can diminish domestic competitiveness.

Trade Surpluses and Deficits

• Trade Surplus:

  • Definition: Occurs when a country exports more than it imports.
  • Enhances GDP and fosters employment growth.

• Trade Deficit:

  • Definition: Arises when imports outweigh exports.
  • Causes capital outflows and may devalue domestic currency.

Foreign Investments

• Foreign Direct Investments (FDI): Involve acquiring control over business operations abroad, promoting job creation and technology transfer.
• Foreign Portfolio Investments (FPI): Entail investments in financial assets without management control.

Visual Explanation

Use diagrams to explore how foreign investments are injected and interact within the economy:

Influence on Achieving Economic Equilibrium

• Balancing Act: Economic equilibrium is attained when total leakages equal total injections, curbing economic volatility.

Policy and Strategic Management of Foreign Investments

• Attracting Sustainable Investments:
  • Enact extensive economic reforms and new incentives.
• Regulatory Frameworks:
  • Require robust legal and regulatory structures.

Key Definitions