5 Sector Economy - Grade: B- PDF

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Using a diagram, outline the main features of the five sector circular flow of income model of the Australian economy. Explain how leakages and injection influence the level of economic activity. Examine how the government can influence the level of economic activity. The five sector economy model is used to illustrate how money flows in and out of the household and business sectors, via leakages and injections from the financial, government and overseas sectors. These levels of leakage and injection influence the fluctuations of economic activity seen in the business cycle, with higher leakages leading to a downturn and higher injections leading to an upturn in economic activity. The government is also able to influence the level of economic activity with the aim of allocating resources efficiently, distributing income equitably and creating economic stability, by implementing monetary and fiscal macroeconomic policy. The five sector circular flow of income model consists of the household, firm, financial, government and overseas sectors and relates them to describe the total flow of money in and out of the economy. The household and the firm sectors rely upon each other to function, as business cannot operate without labour and consumers and as due to Australia’s market economy setup, the individual’s allocation of resources is largely determined by their contribution to the production process, seen in wages. From these two sectors, income not consumed is transferred to financial institutions (such as banks, superannuation funds), the government and overseas as savings, taxation and spending on imports respectively. These processes represent a leakage from the circular flow of income. Conversely, income placed into the financial, government and overseas sectors is re-injected into the economy via investment (such as loans), government expenditure and income from exports respectively. This is demonstrated in the diagram below: When leakages and injections are not equal, the economy experiences a state of disequilibrium. When total leakages are greater than injections, a downturn in economic activity is experienced, known as a contraction in the business cycle. This leads to reduced income, employment, production, interest rates and other affects. However, due to this reduced flow of money between household and firm sectors, there is less income leaked into savings, taxation and spending on imports, so the leakages will decrease and come to equal injections, thus restoring equilibrium. Similarly, when injections are greater than leakages, an upturn in economic activity will occur, leading to increasing employment rates, income, production, consumer confidence and inflation. Due this expansion, there will be more funds available for saving, taxes and international spending, so leakages will rise and the economy will be in equilibrium again. The government intervenes in the economy to influence levels of economic activity by creating sustainable growth and achieving economic stability within the business cycle. Australia aims for growth between 3 – 4%, so the government intervenes via fiscal and monetary macroeconomic policy to achieve this rate. This includes, for example, the adjustment of cash rates through the RBA, which in turn influences interest rates, and consequently the level of savings, which affects the total amount of leakages and can influence economic activity. Additionally, the government implements fiscal policy, which involves government expenditure, an injection into the circular flow model. If the

government chooses to invest in capital goods, it can lead to long term economic growth, while consumer goods can result in a short term economic expansion. These can both be beneficial at different times, with capital expenditure leading to more profitable long term outcomes, while consumer spending can increase growth rapidly, as seen in the GFC. While Overall, the business cycle and circular flow of income model relate the five sectors of the Australian economy and demonstrate how economic activity fluctuates due to a range of factors....