WHAT IS AN ECONOMY?

• How to describe something as complex as an economy

• As a Metaphor ? Eg,

a bowl of spaghetti ?

(Why?)

each strand represents

an economic transaction

As a machine ?

As a biological system

As a model

• Economists thankfully have developed a simple model ( to represent the major areas of activity and flows of money between them) known as “The Circular Flow of Income”

• FEATURES:• 5 major areas (or “Sectors” of activity)• Income/money flows between these sectors

1. Household Sector comprises total population- who are consumers- and producers (owners of resources)

- Households receive income for providing resources ( land, labour, capital,enterprise) to the business sector

2. Business Sector – where all production occurs and sells goods and services

CIRCULAR FLOW OF INCOME2 Sector Model

2 Sector Model

Household Business

Income (Y)

Consumption

3 Sector Model

3. Finance Sector – where people SAVE and BORROW money, eg, banks, building societies, credit unions, superannuation companies, sharemarket, etc.

(Business borrowing is known as INVESTMENT)

3 Sector Model

Household Business

Finance

Savings Investment

4 Sector Model

4. Government Sector – (Federal, state and local) where the Government TAXES people (and businesses) and SPENDS money (eg subsidies to businesses, welfare payments to households)

4 Sector Model

Household Business

Finance

Savings Investment

Govt.

Govt SpendingTax

5 Sector Model

5. Overseas Sector – There are many flows of money in and out of Australia. The most well known flows are payments overseas (IMPORTS) and payments to Australians (EXPORTS) for goods.

5 Sector Model

Household Business

Finance

Savings Investment

Govt.

Govt SpendingTax

Overseas

ExportsImports

Equilibrium: Leakages and Injections

Leakages (Red Lines) are money that leaves the circular flow eg.– Savings– Tax– Imports

Injections (Green Lines) are money that enters the economy eg.– Investment– Govt. spending– Exports

5 Sector Model

Household Business

Finance

Savings Investment

Govt.

Govt SpendingTax

Overseas

ExportsImports

Leakages Injections

If leakages are higher than injections Total Income (Y) will fall

If injections are higher than leakages Total Income (Y) will rise

If leakages = injections Total Income (Y) will not change ie

The Economy is in “EQUILIBRIUM”

Equilibrium: Leakages and Injections