The Two-sector Model of the Economy (Households and Firms) The households (consumers): Require goods and services to satisfy their personal wants Own all resources (i.e. labour, capital, land, enterprise) Sell resources to businesses Gain income (e.g. wage, interest, rent, profit) from such sales The firms/business sector (producers): Uses resources provided by households to produce goods and services Sells those goods and services for income

The Two-sector Model of the Economy Assumptions: Businesses are the only producers All goods and services are sold to consumers Consumers spend ALL their income on goods and services There are no resource inventories Therefore: Total demand (expenditure) = total supply (output) The economy will always be in equilibrium (cont.)

The Two-sector Model of the Economy (cont.) Two groups of decision makers Households (sell their resources) Firms (sell goods and services) Interaction between the two sectors through markets: Resource (factor) markets Product markets (cont.)

The Two-sector Model of the Economy (cont.) Productive resources Factor market Income Household sector Firms sector Goods and Services Product market Expenditure

In the Basic Circular Flow O = Y = E Where: O = output (production) Y = income E = expenditure (demand)

The Financial Sector Saving (S) = Part of the Income that is not spent (leakage) Total income = consumption spending + saving, i.e. Y = C + S Investment (I) = that part of production that is not used for current consumption, e.g. capital goods Total income (Y) = C + I Investment is an injection. If: S > I, the economy contracts S < I, the economy expands S = I, the economy is in equilibrium The financial sector acts as an intermediary between lenders and borrowers

The Government Sector Government taxation (T) reduces households’ disposable income and business funds Taxation (T) is a leakage (outflow) Government spending (G) includes expenditure on collective goods and services and goods and services provided by the business sector, plus transfer payments (social security payments)

The Modified Five-sector Model of the Economy It is a five-sector model of the economy: The household sector The firms sector The government sector The financial sector The external (overseas) sector

The Two-sector Model of the Economy (cont.) Household sector Financial sector Government External Firms Imports Savings Government expenditure Exports Taxation Investment INJECTIONS LEAKAGES Expenditure Income

The Open Economy Total leakages (outflows) are S, T and M Total injections are I, G and X The impact of total leakages/injections on the economic activity is as follows: S + T + M = I + G + X equilibrium S + T + M > I + G + X contraction S + T + M < I + G + X expansion