Question

QUESTION FOUR [25]

“The government of an economy forms a vital part of the circular flow model of income and spending as government plays an important role in achieving equality between the value of total production and total income represented in the circular flow model. This is important, as it shows the direct link between productivity and living standards of the people in a country.”

In terms of the above statement, discuss the type of fiscal policy that government needs to apply in order to achieve equality between the value of total production and total income. Motivate your answer with the aid of a diagram indicating the flows between the sectors of households, firms and government.

Answer 1

Answer: Circular flow of income: It refers to the continuous circular flow of goods, services, and money among different sectors of the economy. The flow of money is the aggregate value of goods and services either as factor payment or as expenditure on goods and services.

In the three-sector model economy, It involves three sectors households, business, and govt.

Income is first generated by production units, then distributed among households for rendering productive services and ultimately comes back by way of consumption expenditure on goods and services by households.

the addition of the govt. in an economy brings two variables like injections ( expenditure like income), and another one is leakage ( like taxation or withdrawal from income).

The fiscal policy of govt. is that govt. expenditure increases the aggregate demand, while taxation reduces the aggregate demand.

AD = C+I+G C= CONSUMPTION, I = INVESTMENT, G = GOVT.)

AS= C+S+T (C= CONSUMPTION, S= SAVINGS, T= TAXATION)

AD = AS

C+I+G = C + S+ T

C is cancelled from both the side now we get,

S+ T = I + G

Leakage = Injections

For this govt. will follow a balanced budget policy.

• In order to achieve equality between value of total production and total income, govt will work on reducing income inequality by redistribution of resources that is taking income from those with higher incomes and providing income to those with lower incomes.  
• the progressive tax system will be designed.
• increase the minimum wage.
• Build assets for working family.
• To contribute towards the maintenance of a growing high employment economy free from excessive inflation or deflation.
• The govt. should increase expenditure in case of deficient demand. The objective of expenditure policy is to pump more money in the system.

CIRCULAR FLOW OF INCOME BETWEEN THE SECTORS OF HOUSEHOLD, FIRMS AND GOVT.