National Income and AD/AS Analysis: Question 3
Syllabus 4.2
Bellamar is a small open economy. Economists have estimated the following annual flows for Bellamar (all figures in $ billion).
| Flow | $ billion |
|---|---|
| Savings (S) | 45 |
| Taxation (T) | 60 |
| Imports (M) | 35 |
| Investment (I) | 50 |
| Government spending (G) | 55 |
| Exports (X) | 30 |
(a) State which three of these flows are injections into Bellamar's circular flow of income, and which three are withdrawals from it. [2]
(b) Calculate Bellamar's total injections and total withdrawals, and state whether Bellamar's national income is likely to be expanding, contracting, or staying the same. [3]
(c) Explain why a circular flow of income diagram for Bellamar must include a "rest of the world" sector, whereas a circular flow diagram for a closed economy would not need one. [3]
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Worked solution
Part (a): Classifying the flows
The circular flow of income has three injections (spending that adds to the flow from outside the households-firms spending cycle) and three withdrawals (income that leaks out of the flow instead of being re-spent domestically):
- Injections: Investment (I) $50bn, Government spending (G) $55bn, Exports (X) $30bn.
- Withdrawals: Savings (S) $45bn, Taxation (T) $60bn, Imports (M) $35bn.
Part (b): Total injections, total withdrawals, and the direction of national income
Total injections:
Total withdrawals:
Since , withdrawals from Bellamar’s circular flow exceed injections into it by $5 billion. More income is leaking out of the flow (as saving, tax and import spending) than is being injected back in. With withdrawals exceeding injections, spending and income circulating around Bellamar’s economy will tend to fall over time, so Bellamar’s national income is likely to be contracting, moving towards a new, lower level of national income at which injections and withdrawals are once again equal.
Part (c): Why an open economy needs a “rest of the world” sector
A basic circular flow diagram for a closed economy shows only households, firms and the government: households supply factors of production to firms and receive factor income in return, spend some of that income (consumption) and withdraw some (saving and taxation), while firms and the government inject spending back in (investment and government spending). All flows of income and spending stay entirely within the domestic economy.
Bellamar, however, is an open economy: it trades with the rest of the world. Some domestic spending leaves the flow to buy imported goods and services (import spending, a withdrawal, since that money is paid to overseas producers rather than recirculated domestically), and Bellamar’s firms also receive spending from overseas customers buying its exports (export earnings, an injection, since it is spending on Bellamar’s output entering the flow from outside). Because these extra flows of income cross Bellamar’s border in both directions, an accurate circular flow diagram for Bellamar must add a distinct “rest of the world” sector to show them - a closed economy, by definition, has no flows crossing its border at all, so no such sector is needed.
Final answers
- (a) Injections: I, G, X. Withdrawals: S, T, M.
- (b) and ($ billion) - since , Bellamar’s national income is likely contracting.
- (c) A “rest of the world” sector is needed because Bellamar’s trade creates cross-border flows (import spending leaving the flow, export earnings entering it) that simply do not exist in a closed economy.