Considering the circular flow model (for a four sector economy), (Points : 3) if
ID: 1212893 • Letter: C
Question
Considering the circular flow model (for a four sector economy), (Points : 3) if leakages exceed injections at some income level, we can know that the level of aggregate demand also must exceed the level of aggregate supply we can know that the system cannot be in equilibrium if there is a deficit in the country's trade balance we can know that the system cannot be in equilibrium if there is a deficit in the country's budget (i.e., taxes exceed govt spending) we can know that saving must equal investment none of the above are (necessarily) true
Explanation / Answer
To analyse the economy as a whole the economists have developed different models. These economic models help us to understand the economic situations in detail. The circular flow of economic activity in a four sector model is one such model. For this purpose the economy is basically classified into four major sectors – households, firms, government sectors and foreign sectors.
But if leakages exceed at some level of injections then simultaneously the demand also must exceed. We can show this in the following way:-
Y=C+I+G ---------------- 1
Where Y is production of goods and services, C is consumption expenditure, I is income level and G is government expenditure.
Now let us introduce taxation to equate the model thus we get;
Y=C+S+T------------------------2
By equating the above two equations we get;
I+G = S+T
But after we introduce foreign sector we can divide investment (I) in foreign investment and domestic investment. Thus we get;
Id+If+G=S+T
Here If = X-M where X is export and M is import
Id + X – M = S+T-G
This is the equilibrium condition
But when any kind of leakages occur at any such level than the economy gears up and takes measures to arrive at the above mentioned equation which is the stage of equilibrium. In the situation of deficits the government must adopt measures such as to increase exports and decrease imports etc. Similarly if S+T exceeds I+G then the government should adopt fiscal measures such as reduction in taxes.
By the adoption of these measures the economy can return back to proper levels of equilibrium.