The equality between saving and investment comes about through the capital market. Some of the flows in the circular flow can go in either direction. Owing to the deficiency of demand for goods and the accumulation of stocks, retailers will place small orders with the wholesalers. It is these actual or realised saving and investment that are identical in national income accounts. If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income.
Thus, the identity iii shows that the value of output produced or sold is equal to the total income received. Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. In other words, Government borrowing crowds out private investment. In other words, Government borrowing crowds out private investment. For example, government will pay wages to household that work as government employees. The amount that the government collects in taxes need not equal the amount that it pays out for government purchases and transfers. Companies who pay wages to workers and produce output.
When households and firms borrow the savings, they constitute injections. Firms spend on investment in order to expand their productive capacity in future. However, households who view the rate of interest as return on savings feel encouraged to save more. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. This may be considered as the firms selling the goods to themselves to add to their inventories. Corresponding to the flows of money in the circular flow, there are flows of goods and services among these sectors. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow.
It is business firms who borrow from the financial market for investment in capital goods such as machines, factories, tools and instruments, trucks. New spending C generates new income Y , which generates further new spending C , and further new income Y , and so on. Rest of the world sector: transforms the model from a closed economy to an open economy. Capital inflow will occur in case of trade deficit or to use the broad term current account deficit which includes invisibles in addition to trade of goods. Tracking the flow of money and finding leaks may help small businesses plan for significant policy changes and anticipate how the government may try to balance its budget. However, actual money flows through the economy are far more complicated.
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. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. Household will receive income from the firm, namely salary and wage, rent, dividend and profit because household has offered factors of production to firm to generate goods and services. On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries.
For instance, government pays billions of dollars each month in pensions and Social Security checks. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. The third flow between countries is borrowing and lending. In year of depression, the circular flow of money income will contract, i. This is so because the flow of money is a measure of national income and will, therefore, change with changes in the national income.
In other words, the flow of money income will not always continue at a constant level. Relation of Aggregate Domestic Output and Expenditure with Trade Balance. Money Income Flows in the Four Sector Open Economy: Adding Foreign Sector: We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Here households have two alternatives used for their income - they can consume it or they can save it. Government borrowing increases the demand for credit which causes rate of interest to rise.
As a result, circular flow of income does not continue at a steady level in a free-enterprise capitalist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy. In addition to the household sector that spends C goods and the business sector that produces the goods, two sectors that are also included in the circular flow of income include the government sector and the foreign sector. This is the domestic money that is available for investment. Further, the factor owners spend this income on goods and services produced by the business entities. When the government is running a deficit, there is a flow of dollars to the government sector from the financial markets.