# Circular Flow of Economy

Pages: 5 (1374 words) Published: November 3, 2008
|This article explains how an economy can become in a disequilibrium and how recessions and booms happens in a market economy. | |The circular flow of income model is a model used to show the flow of income through an economy. Through showing the leakages in| |the economy and the injections, the different factors affecting the economic activities are apparent. Just like a leakage in a | |fish tank a leakage in the economy leads to a decrease in economic activity. | |And just like an injection into a fish tank where the water level rises, an injection in an economy leads to an increase in | |economic activity. To understand how the circular flow of income can be used to show disequilibrium in the economy you must | |first understand what disequilibrium is. Disequilibrium is the state where economic activity is not equal, that is where | |leakages > injections or when leakageswhereas the state of equilibrium is when leakages=injections. Hence disequilibrium is | |when the savings are either greater or less than the investment. | |[pic][pic][pic][pic] | |The basic circular flow of income model consists of six assumptions: | |The economy consists of two sectors: households and firms. | |Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). | |All output (O) produced by firms is purchased by households through their expenditure (E). | |There is no financial sector. | |There is no government sector. | |There is no overseas sector. | |In the simple two sector circular flow of income model (Fig 1) the state of equilibrium is defined as a situation in which there| |is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is: Y = E = O. | |This means that all household income (Y) is spent (E) on the output (O) of firms, which is equal in value to the payments for | |productive resources purchased by firms from households. This can be shown in an example where John earns \$100.00, he doesn't | |save it and spends it all on the goods and services (O) provided by the firms. | |Table all leakages and injections in five sector model: | |LEAKAGES | |INJECTION | | | |Saving (S) | |Investment (I) | | | |Taxes (T) | |Government Spending (G)...