Injections and withdrawals in an open economy with government

Overview

Withdrawal from the circular flow, injection into the circular flow and exports an injection into the domestic circular flow.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a withdrawal from the circular flow, and which three withdrawals appear once an economy has a government and trades abroad?

   Model answer

   A withdrawal, or leakage, is income received by households that is not passed straight back to domestic firms as spending on domestic output. The three are saving, taxation and spending on imports. Each removes purchasing power from the domestic flow, so together they reduce the income available to be earned in the next round.

2. 2

   What is an injection into the circular flow, and which three injections appear in an open economy with a government?

   Model answer

   An injection is spending on domestic output that does not come from the income currently being received by domestic households. The three are investment by firms, government expenditure on goods and services, and exports bought by foreign residents. Each adds demand for domestic output over and above household consumption.

3. 3

   Why is household saving treated as a withdrawal when the money is still in the economy sitting in a bank?

   Model answer

   Saving is income that has been received but not spent on domestic goods and services in that round, so the demand facing domestic firms is smaller than the income paid out. The money has not vanished, and if the banking system lends it to firms it returns as investment, but that return is a separate injection decision made by different people for different reasons. The withdrawal and the injection are treated separately precisely because there is no guarantee they will match.

4. 4

   Why is taxation classified as a withdrawal from the circular flow?

   Model answer

   Taxes on income and on spending take purchasing power away from households before it can reach domestic firms, so the demand for domestic output is reduced. The money goes to the government rather than round the loop. It re-enters as an injection only when the government spends it on goods and services, which is a separate flow shown at a different point in the diagram.

5. 5

   Why does buying an imported good count as a withdrawal from the domestic circular flow?

   Model answer

   The spending becomes income for foreign firms and foreign factor owners rather than domestic ones, so it does not generate domestic output or domestic factor incomes. The purchasing power leaves the domestic loop entirely. This is why the value of imports is subtracted when the contribution of trade to the domestic economy is measured.

6. 6

   Why is investment by firms an injection rather than a redistribution of existing spending?

   Model answer

   Investment is spending on new capital goods such as machinery, vehicles and buildings, and it is funded from retained profits or borrowing rather than out of current household income. It creates demand for the output of the firms that produce capital goods, and that demand is additional to the consumption households finance out of their wages. It therefore enlarges the flow rather than reallocating it.

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