Question

QUESTION TWO
Consider the hypothetical example of Dominion Island that has firms producing only two goods, gold and cotton, the proceeds of which it uses to purchase other goods and services from neighbouring islands through its banks. Assuming that all other required institutions in an economy are prevalent in this island, discuss the circular flow of income and spending in Dominion Island. No diagram is required

Answer 1

The circular flow of income in the economy depicts the mutual exchange of resources between the different sectors of the economy like the households, the firms, the government, the goods market, the labour market, the financial market, and the external market.

In the Dominion island, the firms produce gold and cotton with the help of labour obtained from the labour market (to extract gold or grow cotton). It may also employ other factors of production like land and capital. It will pay wages to labourers, and pay for capital and land, using the revenue from the sales, and keep the surplus as profits. The labourers as well as the firm owners act as consumers since they constitute households. The wages and profits earned by them are spent on goods produced by the domestic firms ( gold and cotton) as well as goods imported from abroad. They will also save some of their income as flows into the financial market as well as borrow from them as a flow out of the financial markets in order to fund their consumption as well as investment. The investment flows back into the production of gold and cotton, some of which is domestically sold and rest is exported. The households and the firms also pay taxes, using which the government funds its expenditure. The government also has public savings as a flow inti the financial market (banks) while it has deficits that are a flow out of the financial markets. In this way, the circular flow of income happens in the economy.