Circular flow of income is an economic model that describes how the money exchanged in the process of production, distribution and consumption of goods and services flows in a circular manner from producers to consumers and back to the producers.
the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Foreigners interact with the domestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. Goods and services produced within the domestic territory which are sold to the foreigners are called exports.
On the other hand, purchases of foreign-made goods and services by domestic households are called imports. Figure 6.4 illustrates additional money flows that occur in the open economy when exports and imports also exist in the economy. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and import goods and services.
A flow of money spending on imports have been shown to be occurring from the domestic business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money expenditure on exports of a domestic economy has been shown to be taking place from foreign countries to the business firms of the domestic economy.
If exports are equal to the imports, then there exists a balance of trade. Generally, exports and imports are not equal to each other. If value of exports exceeds the value of imports, trade surplus occurs. On the other hand if value of imports exceeds value of exports of a country, trade deficit occurs.
In the open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. These days financial markets around the world have become well integrated.
When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M), net capital inflow will take place. By net capital inflow we mean foreigners will borrow from domestic savers to finance their purchases of domestic exports. In this way as a result of net capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets.
On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. Therefore, in case of trade deficit, domestic consumer households and business firms will borrow from abroad to finance their excess of imports over exports. As a result, foreigners will acquire domestic financial assets.
From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net exports, that is, X-M where X represents exports and M represents imports. Imports must be subtracted from the total expenditure on foreign produced goods and services to get the value of net exports. Thus, in the open economy
National Income = C + I + G + NX
where NX represents net exports, X-M.
Since national income can be either consumed, saved or paid as taxes to the Government we have
C + I + G + NX = C + S + T
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