Question

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

Circular flow model in three sector economy-----

In the three sector economy model, there are three sectors--

Households

Business firms

Govt

Besides it ,there are financial institutions ( banking sector) in the economy.

In the above diagram-------

We observe the flow of income and expenditure among household ,firms and govt sector.

* Firstly ,we consider households and firms .households provide factor services ( land,labour,capital,entrepreneurship) to the business firms ,which is real glow, in return, the firms make factor payments ( rent,wages,interest,profit) to households,which is money flow.likewise firms provide goods and services to households( real flow) while households make expenditure on goods and services ,which is money flow .This way circular flow between households and firms complete.

* In between there is financial institutions ,where households make savings and firms make borrowings gor investment purpose.

* Now, here comes govt sector, govt plays a vital role in the three sector economy .It adopts its fiscal policy tools to regulate real flow and money flow to bring equilibrium in circular flow of income ,output and employment.

Govt adopts two fiscal policy tools ---

Govt expenditure

Govt revenue ( taxes)

*In the above diagram ,we see that govt makes public expenditure i.e expenditure on health ,education and tranfer payments ( old age pensions,scholarships,etc) to the households.

* Households pay income tax, gift tax etc to the govt.

* Similarly ,business firms pay corporate taxes ,income tax ,excise duty to govt,while govt provides subsidies, public expenditure for business firms.

* Besides it ,the govt borrows from banks and also keep its saving there.

* Govt expenditure is injection while tax is a leakage in circular flow. So ,if govt needs to increase the flow of income and output in the economy,it increases govt spendings and reduces tax burden.The reason is by doing this ,the govt will increase the disposable income of households and firms,which will boost consumption and investment expenditure. This way aggregate demand will increase.

Hence the circular flow among three sectors completes and equilibrium among them is attained.

Hope it will help you....