Using a Circular Flow of Income diagram explain the factors that determine the level of economic activity in a country’s economy

The circular flow of income diagram illustrates how income flows through an economy. Firms in order to produce goods and services require command over factors of production; entrepreneurs achieve this command by purchasing or hiring the required factors of production. Households supply the labour which is a factor of production
Households are the consumers of the goods and services and they acquire the money which enables them to purchase the goods and services through selling their labour and any other factors of production which they own. If households spent all their income in buying the output of domestic firms and if all the revenue of firms accrued to domestic households – in the form of wages, rent, profit and interest – then there would be a continuous non-varying circular flow of income between domestic households and domestic firms.
However, economic life is not as simple as that. Households have many options on how to allocate their incomes, their income can be spent on domestically produced goods or on foreign produced goods;
Alternatively, not all the income earned is spent. Some of the income can be saved or it may be required in order to pay taxes. Any income which is not channelled back to domestic firms is in effect a withdrawal from the circular flow of income and of itself results in a diminution in the level of activity in the domestic economy.
Withdrawals consist of
(i) savings,
(ii) money spent on buying imported goods and services and
(iii) payments of tax.
Similarly the income of firms is not derived solely from the spending of domestic households.
Domestically produced goods and services are also purchased by
(i) the government,
(ii) by foreign purchasers of the goods which we export and
(iii) by firms who use some of their income to purchase capital goods in the domestic economy as a form of investment. Because government spending, exports and investments increase the level of activity in the domestic economy they are referred to as injections into the circular flow of income.
The withdrawals and injections in the circular flow of income may be related to each other. If people save then banks and other financial institutions will have funds to lend, similarly if tax revenues increase it will be possible (easier) for the government to increase (or maintain) its spending and if our currency is used to buy the produce of foreign firms (our imports) this will provide them with the currency they require in order to buy our exports. The circular flow of income diagram shown below illustrates this analysis. If injections exceed withdrawals the level of expenditure in the domestic economy will rise and consequently there will be growth in the economy. Conversely, if withdrawals exceed injections the level of expenditure in the domestic economy will rise and consequently there will be a decline in growth in the economy.


Circular of Income with Foreign Trade and Government Sector

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