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Exploring how the government acts as a participant in the economy through taxes, transfers, and spending.
What happens to the economy if everyone suddenly decides to save every penny they earn? While it sounds responsible, it could actually cause the entire economic engine to stall.
In a simple economy, money flows between households and firms. However, the Government acts as a powerful third player. It interacts with the flow in two primary ways: through Taxes () and Government Spending (). When the government collects taxes from households (income tax) or firms (corporate tax), it removes purchasing power from the private sector. Conversely, when the government spends money on infrastructure, education, or defense, it pumps money back into the system. Additionally, the government provides Transfer Payments, such as social security, which redistribute income back to households without a corresponding exchange of goods or services.
Quick Check
If the government increases transfer payments to households, does this represent a direct purchase of goods and services?
Answer
No, transfer payments are a redistribution of income, not a payment for a good or service produced.
Suppose an economy has the following values: 1. Households save billion. 2. The government collects taxes billion. 3. Firms invest billion. 4. The government spends billion.
Quick Check
If , what will happen to the overall level of national income?
Answer
National income will decrease because more money is leaving the flow than entering it.
The government uses Fiscal Policy to manipulate the circular flow. If the economy is sluggish, the government can use Expansionary Fiscal Policy by increasing or decreasing . This increases the total injections relative to leakages, causing the circular flow to expand and national income to rise. Conversely, if the economy is overheating (inflation), the government may use Contractionary Fiscal Policy by decreasing or increasing . This increases leakages relative to injections, slowing down the flow. The goal is often to reach a state where the 'leakage' of taxes and savings is perfectly offset by 'injections' of spending and investment.
Imagine an economy in equilibrium where . The government decides to cut taxes () by billion to stimulate growth. 1. Initially: . 2. After the cut: . 3. Now: . 4. Because , there is a net injection into the economy. 5. This leads to an increase in production and household income as the 'extra' money circulates through the system.
A government wants to increase spending () by million but is required by law to keep a balanced budget, meaning they must also increase taxes () by million. 1. increases by (Injection). 2. increases by (Leakage). 3. While it seems they cancel out, the Balanced Budget Multiplier suggests that because households would have saved a portion of that taxed money anyway, the increase in actually stimulates the economy more than the increase in dampens it. The net effect on national income is typically positive.
Which of the following is considered a 'leakage' in the circular flow of income?
If , what is the most likely outcome for the economy?
Expansionary fiscal policy involves increasing taxes to encourage more government spending.
Review Tomorrow
In 24 hours, try to sketch the 3-sector circular flow model from memory and label the specific points where , , , and enter or exit.
Practice Activity
Find a recent news article about a government budget announcement. Identify whether the proposed changes in spending and taxation represent an 'injection' or a 'leakage' relative to the previous year.