Economics 2.3 Growth Assignment 2 Ashwin Lim.

Part One B Intro to the Circular Flow Model

The Five Sector Circular Flow Model

What are the Assumptions and Limitations of the Circular Flow Model? In the Two Sector Circular Flow Model, it is assumed that: In the Two Sector Circular Flow Model, The limitations are: The economy consists of two sectors: households and firms. There are less money flows. There are less real flows Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). There are only 4 flows within a two sector Circular Flow Model. 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.

Two Sector Model In the Two Sector Circular Flow Model, the only sectors shown are the households and firms sectors. This means that there are three other sectors of the Circular Flow Model that are excluded. In this model, there is an interdependence between only the 2 sectors (E.g. Households & Firms). Where as in other model types, there is more than one type of interdependence (E.g. Financial & Firms)

Three Sector Model The Three Sector Model includes the Household, Producer / Firms, and the Financial Sector. The Household Sector provides Firms with labour and consumer spending, they then give their savings (income left over after expenditure) to Financial Sector. The Financial Sector, receives the savings from Households, and also gives money to Firms for them to use as investments. The Firm / Producer Sector provides Households with it’s output (E.g. Goods), and in turn it receives a source of income from the Expenditure of Households. It also receives money for investments from the Financial Sector.

Four Sector Model The Four Sector Model contains the same three sectors as the three sector model, but now includes the Government Sector as well. The Government Sector provides the household sector with transfer payments in return for direct tax, the government sector also provides the producer sector with subsidies in return for indirect tax. Injections E.g. subsidies are also provided by the government.

Five Sector Model In the Five Sector Model the overseas sector is now included, this is the model that provides the best outlook of an economy. The overseas sector provides the producer sector with imports in return for export reciepts, and exports for import payments..

The Difference between Injections and Withdrawals Injections is the amount of money entering the economy (e.g. exports). Withdrawals is the money that is being taken out of the economy (e.g. imports). If withdrawals are bigger than it’s injections the country would face a deficit / negative economic growth. If withdrawals are less than injections, then a country would be facing a budget surplus / economic growth.

Why are Injections, Important for Economic Growth? In the Equilibrium, leakages equal injections and the circular flow stays the same size. If injections exceed leakages, the circular flow grows (results in economic prosperity) But, if they are less than leakages, the circular flow shrinks. So if injections are higher than leakages it will result in a growth of the economy, therefore injections are important.

Part two B using the Circular Flow Model

How does an Increase in Household Savings cause Growth? An increase in household savings means that savings increases, this means that the financial sector now has a greater amount of income to provide to firms in the form of investment loans. The increase in investment loans means that firms are now more willing and able to buy capital goods (E.g. machinery), so productivity is increased because the firm has become efficient, which in turn results in production and growth increasing.

How does an Increase in firm’s Investment cause Growth? An increase in firm’s investment leads to an increase in revenue for the firm and as a result, the firm purchases more resources because they are more willing and able to afford resources. This means that consumer income increases because the firm is now earning more income because of increased sales. The amount of goods produced by the firm increases, because they want to increase their sales so consumer spending increases because it is now cheaper to buy the product produced by the firm so growth of the business / firm should increase.

How does an Increase in Resource use cause Growth? As output increases, the amount of resources required to produce these goods and services increases because there is now a greater number of goods and services being produced. Therefore consumer incomes increases. Producers must employ more people to cope with the increased output, and as a result the level of goods and services produced increases. Consumer spending also increases because there is now a larger number of the goods and services available. Producers will lower the price to ensure they sell the product which results in growth increasing because there is higher consumer spending.

How does an Increase Consumption cause Growth? Consumption spending increases because prices has decreased, therefore spending on goods and services increases, because consumers are now more willing and able to afford the goods and services at every price. This leads to an increase in confidence for firms because their sales have increased which results in an increase in output and investment also increases. because of the increased output consumer incomes increase because the firms need to hire more staff to cope with increased output. This leads to an increase in household savings because households now have greater surplus income which they will give to the financial institutions as savings, this leads to an increase in growth because the financial sector will use the savings to provide firms with investment loans.

How does an Increase in Exports cause Growth? An increase in exports due to tariffs being removed leads to an increase in export receipts because there are a greater number of exports This leads to an increase in firms profits because they are now earning a higher income from increased export receipts. Which results in an increase in investment because firms have more money to spend, this increases output because the increased investment has lead to better efficiency. This leads to an increase in consumer incomes because the firm needs to hire more people to cope with increased output. This ends in an increase in growth because there will be greater consumer spending due to increased incomes.

How does an International Event being held in NZ cause Growth? An international event being held in New Zealand results in an increase in tourism, so export receipts increase because the tourists will spend their money on goods and services in New Zealand. Therefore, spending in the various regions increases because of increased tourism, so firm’s confidence in investment increases because firms have a greater income due to increased spending by tourists to New Zealand. Therefore employment increases because firms may need to hire more staff to cope with the increased demand. Therefore incomes increase because of the greater amount of people working. This results in an increase in spending because consumers are now more willing and able to afford goods and services at every price so growth occurs because there is increased consumer spending.