Disequilibrium in the Circular Flow of Income - Essay Example

Running Header: Disequilibrium in the Circular flow of Income Name: Course: Institution: Tutor: Disequilibrium in the Circular if Income The circular flow of income is an economic model that explains how money circulates within an economy, between businesses and individuals. Individuals spend their income by consuming goods and services offered by businesses, pay taxes and invest in the stock market. On the other hand, businesses use money spent by individuals to pay for capital, pay employees and purchase materials to manufacture products. All expenditures by individuals become the income of businesses and the expenditure of the businesses becomes the income of individuals. The circular flow of income in any economy consists of leakages and injections. Leakages consist of the net tax, savings and imports while injections consist of investments, exports and government purchases. The presence of sharp leakages in an economy can lead to sharp decreases in economic activities. If leakages are greater than or less than injections, then the circular flow of income enters a state of disequilibrium. Thus, disequilibrium occurs when the net savings are either less or greater than the investment (Mankiw, 2006). In a state of equilibrium, leakages equal injections and hence the circular flow remains the same. If by any chance the injections exceed leakages, the circular flow grows large, that is there is economic growth. But if the leakages exceed injections, the circular flow shrinks and hence the economy undergoes a recession. Primarily a disequilibrium in the circular flow of income increase from changes in any of the five sectors which make the model. The five sectors are: households; finance; firms; government and external sectors. Each of the five sectors plays a vital role in regulating the state of equilibrium in the circular flow of income. The household comprises of the consuming units in the society and is also the source. The primary function of the household sector is to supply the firms sector with the required factors of production such as land, human capital, enterprise and real capital. All these factors are supplied by the factor owners in return for reward. The entrepreneurs combine the factors and bear the risks associated with the production process. The firms sector comprises the basic productive units in an economy. The main function of firms is to supply private services and goods to domestic and foreign households and firms. To do this, the firms employ factors of production and pay for their services. According to Mankiw (2006) most of the production is done by private firms and is motivated by the desire to maximize profits. The financial sector is made of mainly banks and the central banks. These institutions are responsible for controlling the circulation of money and for providing the day to day requirements of the economy. Primarily, the government sector fits into the circular flow system as a spender and receiver of income. The government provides collective goods and services which are consumed by other sectors (Mankiw, 2006). Finally, the external sector is primarily concerned with foreign exchanges (imports and exports) and hence provides another set of injections and leakages in the circular flow system (opportunities for loss of equilibrium). The diagram below illustrates a simple circular income flow system. Figure 1: Circular Flow of Income The circular flow system will naturally adjust when new injections flow into the system or withdrawals are made out of it. An injection of new spending into the circular flow system will increase the flow and withdraws will have the reverse effect. A net injection into the circular flow system is the overall effect of the injections in relations to the total withdrawals following a change in economic variables. To keep inline with the prevailing economic systems, circular flow systems are systematically adjusted to take into account the effect of withdrawals and injections. Households may decide to save their incomes instead of spending it. This will have the impact of reducing the circular flow of funds (Mankiw, 2006).The leakages which the government provides are mainly through the collection of revenue (taxes). The taxes are provided by households and firms and constitute an important source of revenue for the government in an economy. Since the government takes the taxes from the people, the taxes constitute a leakage out of the circular flow system and hence reduce the capability of households and firms to spend in current goods and services. There are a number of ways in which markets react to any disequilibrium in the circular flow system. Primarily, markets act as intermediaries in transmitting cash flows between various sectors such as households, financial institutions and government. In most cases, investors do not purchase productive assets directly, but instead make deposits in banks. The banks use these deposits to make loans, buy securities and finance capital expenditure on goods which constitute investments. In addition, markets play a key role in redirecting funds flow between the government and private sectors within an economy. Without the market, the governments would always have to balance its budget each year (Mankiw, 2006). With the help of financial markets, the government budget does not always have to be balanced. If for instance government purchases exceed net taxes, the government gets a net deficit and hence a state of disequilibrium occurs in the circular flow system. To cover for such a deficit, the government borrows from private financial sectors. This can be through the sale of bonds to private investors in the financial market. This approach is called the income and expenditure approach. Essentially, the approach enables the government to check the supply of funds into an economy and hence contain undesired disequilibrium in the circular flow system. In another aspect of the income/expenditure approach, market players such as the government can collect more in net taxes than is necessary to be spent in the purchase of capital goods and services. In this case, the budget is said to be in surplus and any surplus funds can be used to repay past debts. This results in a state of equilibrium in the circular flow system (Mankiw, 2006). But if an economy runs on too much of a deficit, heavy borrowing from the financial markets may decrease the amount of savings available to meet the economy’s savings needs. This may cause a recession and hence undesirable disequilibrium in the circular flow system. The market also uses the withdrawals and injections approach to contain disequilibrium in the circular flow system. Injections result in the expansion of an economy’s planned expenditure. As an example, suppose the circular flow system is initially in a state of equilibrium with total planned expenditure equal to the economy’s gross domestic product. In this case, products and services are produced at the rate in which they are consumed and hence the level of inventory remains constant. But if a situation arises that excites investments, producers may increase their output of goods to satisfy the increase in investment demand. The increased investment causes disequilibrium in the circular flow system (Mankiw, 2006).The other sectors will react to this disequilibrium by increasing their proportional outputs and inputs hence adding to the expansion of the economy. In this way, the original economic stimulus which began with increased investments spreads through the economy and consequently the GDP and domestic incomes rise steadily until a new equilibrium is attained. Thus, the effects of disequilibrium are controlled. The withdrawal approach works in reverse if the equilibrium is disturbed by decreases in some categories of planned expenditure. As an example, suppose that an economic crisis reduces a country’s exports. The first effect will be that the makers of the country’s export goods will find inventories rising. To bring the inventory level in line with the economy, the producers may cut the level of output. Sometimes, workers may be laid off or work less hours and their income level may fall. As a result, households cut down on consumption expenditure in line with the principle of the marginal propensity to consume. As the process continues, the level of domestic incomes and Gross Domestic Product decrease and before long, a new equilibrium level is reached. But in the new equilibrium, the economy’s real GDP will have decreased more than the original change in exports. This gives an illustration of the multiplier effect operating in reverse (Mankiw, 2006). In conclusion, a state of equilibrium exists in the circular flow of income when the level of planned expenditure (consumption, investment, government purchases and net exports) is equal to the economy’s gross domestic product. In that case, the economy’s total planned purchases will be equal to the economy’s total production and there will be nil unplanned inventory changes for the economy. However, when there are discrepancies in the level of planned expenditure and the economy’s GDP, then a state of disequilibrium occurs. In disequilibrium, injections either exceed or are less than the volume of leakages. When the injections are more than the leakages, the economy grows (expands) but when the injections are less than the leakages, the economy shrinks (enters a recession). Markets respond to disequilibrium in a number of ways such as the withdrawal and injections approach. Reference Mankiw, G 2006, Principles of Economics, London, Thomson Read More