Based on a simple circular flow (inner-tube) model of the economy, what would be

Question

Based on a simple circular flow (inner-tube) model of the economy, what would be the effect on the level of income resulting from each of the following changes? Assume in each instance the only the listed variable changes (autonomously), and in each case indicate whether the level of income would increase, decrease, remain the same, or change but in an indeterminate direction.

a. Investment increases

b. imports increase

c. exports increase

d. saving increases

e. taxes increase

f. government spending increases

Now assume that (for a two-sector economy

Explanation / Answer

Simple Circular flow of income

a. Investment Increases: Increase in investment greases the economic activities and production and employment opportunities opens up. In this way, Income increases.

b. Import Increases: Import forms the leakages of income, hence domestic income flows out. Thus, in short run it would decrease the income.

c. Export Increases: Export brings home valuable foreign exchange and increases income exporting country.

d. Saving Increases: saving Reduces the spending and in short run it reduces the income since spending of one person is income of another person.

e. Taxes Increase: Taxes reduces the purchasing power of people and investment also. So income decreases

f. Govt Spending: Govt spendings increases income

Saving Exceeds the investment

Keynes: According to keynes in such situation there would be fall in employments and output and recession would step in

Classical: According to classical economists full employment is general phenomenon and inequality in saving and investment would be equalised by change in rate of interest. Rate of interest would fall and investment increases, finally both would be equalised.

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