The most comprehensive circular flow model includes the foreign sector. In an earlier article the discussion included the simple or basic model and the one with “Three Sectors” and “Three Markets.” Adding the foreign sector highlights the role of trade with the Rest of the World (ROW). In those models we assumed U.S. to be a “closed” economy. Now we open our borders for imports and exports and other international transactions.
Four Sectors, Three Markets:
The complete circular flow model, with all four macroeconomic sectors (household, business, government and foreign) and all three macroeconomic markets (product, resource, and financial), is presented in the diagram below.
The final circular flow diagram extends the previous version to include trade flows with the rest of the world--which is shown as connected to the “Businesses.” Trade with the ROW consists first of exports of goods, services, income and transfers represented by a flow into firms since money is being used by foreigners to purchase the exported products. Second, imports of goods, services, income and transfers are subtracted away from firms, resulting in an arrow from firms to the ROW. This adjustment accounts for the fact that measured expenditures made by households, the government, and firms in an open economy, will consist of purchases of both domestic and imported goods. The expenditure on imports is considered another “leakage” from the economy and the income from exports is treated an “injection” into the economy. The two are supposed to be balanced in the long run but unfortunately in case of the United States we are running huge deficit in our balance of trade for past many decades. Thus, we owe trillions of dollars to foreigners.
Here is a summary of the important elements and parts of the circular flow of the economy:
Sectors: Households, Businesses, Government, and Foreign (International)
Markets: Products (Goods and Services), Factors (Resources), Financial Institutions
Sources of Leakages: Households for Savings, Taxes, and Expenditure on Imports
Instruments of Injections: Investments, Government Purchases, and Income from Exports
[Savings return as investments, taxes as government purchases, expenditure on imports as income from exports]
National Income Accounting
Now that we have completed the last of the circular flow models of an economy, the rest of the chapter will focus on defining and developing the equation for measuring the GDP—the Gross Domestic Product, GNP—Gross National Product, National Income and other related concepts.
The essence, the core, of the circular flow is the flow of payments between the household and business sectors through the product and resource markets. This core flow can be divided into four parts, each of which is important to the study of macroeconomics.
v Gross domestic product, or GDP, is the sum of all the revenue received by the business sector (firms) for the production of final goods and services sold to the household sector and the Rest of the World. All arrows going in the firms block.
v Factor payments are wage, interest, rent, and profit payments made by the business sector to hire labor, capital, land, and entrepreneurship resources from the household sector. This is the arrow indicating the money flow out of the firms and going into the households.
v National Income is the income earned by the household sector for supplying labor, capital, land, and entrepreneurship resources to the business sector.
v Consumption expenditures are payments made by the household sector to purchase gross domestic product from the business sector (firms).
Note: Please look for a separate article explaining the methods of measuring GDP.
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