Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from overseas and makes payment for them which is leakage from the circular flow. The households may receive transfer payments from the foreign sector for the services rendered by them in foreign countries.
Conversely, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Likewise, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking etc. for which they receive payments from overseas. These are the leakages from the circular flow.
Like the business sector modern governments also export and import goods and services and lend to and borrow from foreign countries. For all the exports of goods, the government receives payments from abroad.
Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education etc. and also when the government provides shipping, insurance and banking services to foreigners through the state owned agencies. It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the circular flow.
Conversely, the leakages are payments made for the purchase of goods and services to foreigners. In the in the below diagram, the circular flow of the four sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the diagram and investment, government purchases and exports as injections into the circular flow on the left side of the figure.
Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors – the household, the business and the government. These outflows and inflows pass through the foreign sector which is also called the “balance of payments sector”.
If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance payments. But in the long run, exports of an economy must balance its imports. This is achieved by the foreign trade policies adopted by the economy.
The whole analysis can be shown in simple equations:
Y = C + I + G ……Equation (1)
Where Y represents the production of goods and services, C for consumption expenditure, I for investment level in the economy and G for Government expenditure respectively.
Now we introduce taxation in the model to equate the government expenditure.
Therefore Y = C + S + T ……….Equation (2)
Where S is saving T is taxation.
By equating (1) and (2), we get, C + I + G = C + S + T
Therefore, I + G = S + T
With the introduction of foreign sector, we divide investment into domestic investment (Id) and foreign investment (If) and get Id + If + G = S + T
But If = X – M, where X is exports and M is imports.
Id + (X – M) + G = S + T
Id + (X – M) = S + (T – G)
The equation shows the equilibrium condition in the circular flow of income and expenditure.
Circular Flow of Income in a Four Sector Economy
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