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Evaluate how the relative size of injections into and leakages from the circular flow of income can affect the
ability of a government to achieve its macroeconomic aims. [25]

Cambridge A level 2019

Quick Answer:

Traditionally, main macro-economic aims of gov ernment policy can be seen as the achievement of full employment, price stability, economic growth and a balance of payment equilibrium.

Though not all governments will share these objectives, yet it is also true that there will be trade-offs and poten tial conflicts between these objectives, and differ ent governments will attach differing priorities to them in different times.

For instance, it is important to keep unemployment levels as low as possible for high unemployment is expensive for the government and, therefore, for the taxpayer.

Then there is the cost to the whole economy as unemployment involves a loss of potential output and hence lower living standard in general.

Young unemployed workers may inflict other external costs on the society, crime for example.

Likewise, control of inflation is also important because if inflation gets out of control, the economy stops growing.

The authorities are forced MM to raise interest rates to counter inflation.

At higher interest rate consumers stop borrowing to spend and firms also reduce borrowing to invest.

Exports become less competitive and the economy may well drop into a recession.

Economic growth is a measure of rate of change of real GDP over a period of time.

High rate of growth can be achieved by bringing unemployed resources at work or alternatively, by improving productivity of existing resources.

Governments seek to achieve high but sustainable growth rate mainly because it leads to improved living stan dards and economic stability.

Lastly, balance of payment equilibrium is important for a persistent BOP deficit results in a decline of a nation s foreign currency reserves and a run on its exchange rate.

Ultimately, it necessitates borrowing and the country accumulates foreign debts, which have to be repaid with interest in future In the context of government’s macroeconomic goals, circular flow of income is a useful model for it shows how changes in flows of withdrawals and injections can affect these objectives.

A basic cir cular flow of income shows the flow of resources from consumers (households) to firms, and the flow of products from firms to consumers, as well as money flows consisting of consumers' income arising from the sale of their resources and firms’ revenues arising from the sale of their products.

In the real world, however, not all income gets passed on round this flow; some is withdrawn.

At the same time, incomes are injected into the flow from outside.

So, withdrawals (W) (or leakages) arc incomes of households or firms that are not passed on round the inner flow.

Withdrawals equal net saving (S) plus net taxes (T) plus import expenditure (M): W = S + T + M.

Saving is income that households choose not to spend but to put aside for the future and net saving (S) refers to saving minus any borrowing or drawing on past savings by households.

Net taxes' (T) represent the net flow to the government from households and firms, it consists of total taxes minus benefits.

Expenditure on imports constitutes the third withdrawal from the inner flow as this money flows abroad.

So the total withdrawals are simply the sum of net .

saving, net taxes and the expenditure on imports In contrast, injections refer to the expenditure on the production of domestic firms coming from outside the inner flow of the circular flow of in come.

Injections equal investment (I) plus govern ment expenditure (G) plus expenditure on exports (X).

Investment (1) is the money that firms spend after obtaining it from various financial institutions - either past savings or loans, or through a new issue of shares while Government expenditure (G) is the money a government spends on goods and services produced by firms.

However, government expenditure in this model does not include state benefits.

Lastly, export expenditure (X) is the flow of money into the circular flow from abroad when residents abroad buy our exports of goods and services.

Total injections are thus the sum of in vestment, government expenditure and exports: J = I + G + X.

So, according to the circular flow of income model an economy is in equilibrium when planned withdrawals equal planned injections (W = J).

This suggests equilibrium where aggregate demand equals aggregate supply.

However, when injections do not equal withdrawals, a state of disequilibrium will exist.

This will set in train a process to bring the economy back to a state of equilibrium where injections are equal to with drawals.

To illustrate this, let us consider the situation where injections exceed withdrawals (W<J).

Also, the balance between exports and imports will tend to deteriorate.

The higher demand sucks more imports into the country, and higher domes tic inflation makes exports less competitive and imports relatively cheaper compared with home produced goods.

Thus imports will tend to rise and exports will tend to fall.

Now let's consider the situation where withdrawals exceed injections (W> J).

This could result from a fall in business confidence so that investment has fallen.

Or else there has been an increase in tax rate so that withdrawals have risen.

This excess of withdrawals over injections will lead to a fall in national income.

But as national income falls, so households will not only spend less on domestic goods (Cd), but also save less (S), pay less taxes (T) and buy less imports (M).

This will continue until withdrawals have fallen to equal injections.

At that point, national income will stop falling, and so will withdrawals.

Equilibrium has been reached at a lower national income.

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