The National and International Economy

THE NATIONAL AND INTERNATIONAL ECON0MY

The output of an economy has a significant influence on its inhabitants’ living standards. The higher the output the more goods and services people can enjoy. The level of output is influenced by the total level of demand for the country’s goods and services. Some of the demand will come from foreign countries just as some of the goods and services produced will be sold to other countries.

THE CIRCULAR FLOW OF INCOME:-

The circular flow of income illustrates how the macro economy works. It shows how output generates income which is then spent and it shows the relationship between households, the government and the foreign trade sector

A TWO SECTOR MODEL:-

A simple model of the economy in which there are only two sectors, firms and households, is illustrated in Figure 26. I.

Firms are the producing units which hire services provided by the people from the households. For these services firms pay wages (for labor), rent (for land), interest and dividends (for the services of capital).There is therefore, a flow of factor services from households to firms and a flow of income from firms to households. These flows are represented by the upper arrows in Figure 26.1.

In this model, households are also the purchasers of the national output. There is a flow of spending from households to firms and a flow of goods and services from firms to households. These flows are represented by the lower arrows in Figure 26.1 .The costs of production represent the incomes paid to households.

LEAKAGES AND INJECTIONS:-

The simple model is very unrealistic because even in the simplest economy all the income received by households is not spent some of it is saved. Saving represents a leakage (or withdrawal) from the circular flow of income because it is part of the income paid out by firms which is not returned to them through the spending of households. When saving takes place, firm’s expenses will be greater than their receipts and some of their output will remain unsold. They will react by reducing output so that income and employment will fall. If households always save some fraction of their income and there are no other expenditures to offset this leakage, income must eventually fall to zero.

Fortunately there is an offsetting expenditure in the form of investment. The first model of the economy assumed that firms only produced consumer goods and services which were in turn bought by households. In fact, some firms produce capital goods for sale to other firms. This expenditure on capital goods adds to the circular flow of income; it has the opposite effect to a leakage and causes output and income to expand. Investment is an injection.

Figure 26.2 incorporates the saving leakage and the investment injection. The diagram concentrates on money flows; for purposes of simplification the real flows (i.e. goods and services) have been omitted.

A MORE REALISTIC MODEL:-

To make the model more realistic it is necessary to take into account the role that the government and the foreign trade sectors take in determining the level of economic activity.

FOREIGN TRADE:-

Some part of the expenditure of households does not flow back to domestic firms because households buy foreign products as well as home produced products. These imports are a leakage from the circular flow because they represent income paid by firms which does not flow back to them. Exports are an injection into the circular flow because this spending by foreigners on home produced output is an additional source of income which is not generated within the domestic system. If exports exceed imports there will be an expansionary effect on income while an import surplus will have a depressing effect on income.

GOVERNMENT:-

Government spending takes several forms. Government spending on goods and services is an injection because it adds to real output and creates employment. Transfer payments (e.g. state pensions and unemployment related benefits) do not, directly generate output and income — they transfer existing income from taxpayers to the recipients of the benefits.

Taxes are a leakage because