Describing the open economy circular flow model


How to describe the open economy circular flow model

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  1. The circular-flow model of the economy is a simplification showing how the economy works and the relationship between income, production and spending in the economy as a whole.

    The circular-flow model of an open economy shows the workings of an economy that is open to foreign trade.

    It is different to a closed economy because it includes the foreign sector.

    Four sector diagram

    [caption id="attachment_17547" align="alignnone" width="675"]An open economy circular flow model An open economy circular flow model[/caption]

    Participants Household sector

    Households are the major consumers of economic goods and services – they use their income to buy from firms.

    Households are the primary economic participants because they are the owners of the four factors of production.

    Households sell factors of production in the factor market to firms.

    Households receive a remuneration from the firms in the form of wages, rent, interest and profit.


    Firms/business sector

    Firms purchase the factors of production from the household in the factor market.

    Firms use the factors of production to produce goods and services.

    Businesses sell goods and services to households, government and the foreign sector.

    Businesses receive an income from the other three participants (households, government and the foreign sector).

    The state/public sector

    This refers to local, regional and national government.

    The state provides the households and businesses with public goods and services.

    The state receives taxes from households, e.g. income tax.

    The state receives taxes from the business sector, e.g. company tax.

    The state spends money in the economy. (G)


    Foreign sector

    There is a flow of goods or imports that flow from the foreign sector and are paid for by the individual households, businesses and the public sector.

    These imports can be seen as expenditure by individual households, businesses and public sector. (A monetary outflow.)

    There is also a flow of goods and services to the foreign sector from businesses (exports).

    These exports will result in an income for individual households, businesses and public sector. (A monetary inflow.)


    Interaction between participants

    Households provide production factors to producers (firms).

    Households receive an income (Y) in return – rent, wages, interest and profits.

    Households purchase goods and services from firms.

    Firms receive income from sales revenue.

    Households and firms purchase goods and services from the foreign sector as imports (M).

    The foreign businesses receive money from firms and households.

    Firms sell goods and services to the foreign sectors, and this is called exports (X).

    Households and firms pay taxes to the government. (T)

    The government provides public goods and services to households and firms.

    The unexhausted (unspent) part of the household and firms’ income earned is saved in the financial sector of the economy. (S)

    The money invested by firms and households is known as savings (S).

    The funds received by the financial sector are used by firms/ businesses to purchase infrastructure for the production of goods and services.

    This flow of money from the financial sector for use by firms is known as investment (I).

    Further readings on open economy circular flow model

    Circular flow of the economy

    Circular flow model explanation



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