1. Circular Flow A. The circular flow model or diagram presents a picture of how

Question

1. Circular Flow

A. The circular flow model or diagram presents a picture of how money flows through an economy. Within this flow, there are both injections and leakages.

I. What are the three types of injections? (3 points)

II. What are the three types of leakages? (3 points)

B. Consider an economy in which Y =2200, C = 800, G = 600, S = 400, and NX = 200. Find investment and taxation. (2 points)

C. Consider an economy in which I = 1000, S = 1000, T = 400, G = 600, and NX = 0.

I. Explain why this economy is not in equilibrium. (2 points)

II. What is needed to return this economy to equilibrium? (3 points)

Explanation / Answer

(A)

(I) The three injections are: Gross domestic private investment, Government spending and Exports.

(II) The three leakages are: Savings, Tax (imposed by government) and Imports.

(B)

Gross consumption = Y - S = 2200 - 400 = 1800

Net consumption (C) = Gross consumption - Tax

800 = 1800 - Tax

Tax = 1800 - 800 = 1000

Also, in equilibrium, Y = C + I + G + NX

2200 = 800 + I + 600 + 200

2200 = 1600 + I

I = 2200 - 1600 = 600

(C)

(I) In equilibrium, Y = C + I + G + NX

Y - C = I + G + NX

S = I + G + NX

1000 = 1000 + 600 + 0

1000 = 1600

Both sides are not matching, revealing a disequilibrium.

(II) For equilibrium to be restored, savings must increase by 600. To increase saving by 600, consumption has to fall by 600.

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