Explain the circular flow of income in an open economy?

Published: 06th April 2011
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Circular Flow of income in an open economy
*INTRODUCTION:
~ The open economy consists of five sectors.
~ These comprise of households, business firms, financial sector, government sector and foreign sector.
~ The inclusion of foreign sector indicates that the economy has trade relations with other countries in the world.
~ Thus, the economy is related to imports, exports, borrowing and lending with foreign countries and financial institutions.
*ILLUSTRATION:


*EXPLANATION:
~ The above illustration depicts the flow of income in an open economy consisting of five sectors, namely, households, firms, financial sector, government sector and foreign sector.
~ The households provide the factors of production to the firms and get the reward from the firms in the form of rent, wages, interest and profits.
~ The households incur consumption expenditure through purchase of goods and services not only from the domestic firms but also from the foreign sector.
~ Thus, it becomes the income for the domestic firms and also for the foreign sector due to the imports undertaken by the households.
~ Also, the households also save a part of their income which becomes the investment expenditure of the firms. The households also pay taxes to the government and in turn, benefit due to public expenditure incurred on infrastructure, education, transfer payments etc.
~ The firms purchase goods and services from the foreign sector and these become the imports of the economy. The firms also supply goods and services to the foreign sector and these become the exports of the economy. So it is the net value of the imports or the exports that are injected in the money flow of the economy.
~ The firms pay various taxes to the government and the government, in turn, Purchases goods and services from the firms and also provides them with various subsidies.
~ The government collects revenue by way of various taxes and, in turn, incurs public expenditure when public expenditure exceeds public revenue, the government resorts to public borrowing.
~ The foreign sector also plays a pivotal role in the functioning of the economy by way of exports and imports as well as through the financial sector by way of lending and borrowing.
~ Thus, the circular flow of national income includes the net of export i.e total exports total imports. The value of net exports depends on the value of exports and thus can be positive or negative.
~ Positive net exports add/inject money in the circular flow of national income, whereas negative net exports reduce the flow of money in the national income.
*CONCLUSION:
~Thus, the foreign sector affects the overall economic functioning of the nation.
~ The national income is measured by total expenditure that includes the net of exports.


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