How equilibrium income is established in an open economy with a government

A-Level: Economics

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What this model is showing is that National Output, National Income and National Expenditure all equal the same. So for example if £100b of output occurs, this total goes to reward the factors of production all of which have been used to produce the goods and services. Then, the income gained by the public is used to purchase the goods and services that were produced. It is this spending that completes the circular flow. It is this revenue from this spending that enables firms to produce the goods and services for the following years and so the whole process starts again, hence the circular flow of income.
When this happens national income is said to be in equilibrium, by this I mean aggregate demand and aggregate supply are equal. Therefore the same amount of goods will be produced each year because the demand for the goods and services is equal to the total amount being supplied. However this doesn’t happen in an open economy.

In reality a circular flow of income in an open economy with a government is subject to many leakages and injections. The model above is a very simple economy that doesn’t take part in international trade (close economy) and there is no government spending and taxation. Also the model above assumes that people spend all their income. This isn’t really very realistic. People are likely to save part of their of their income for retirement and old age. So this is a leakage from the circular flow of income as it means that some of the income gained from firms is not passed back to them, which would result in a build up of stock. If £10b of saving takes place there will be £10b of unsold goods which would lead to firms cutting back production in the future.
However this build up of stock may be purchase by firms who decide to buy the stock to build up their capital and use it as an investment. This is an injection into the circular flow of income. So if there were savings of £10b taking place but also £10b of investment in unsold goods taking place the leakages and injection would balance each other out and the economy would still be at equilibrium.

Equilibrium will exists when S = I and when Y = C + I

Taking this into consideration the circular flow income model would now tend to look more like the one below. Although a model like this would still only be seen in an economy that had no government to tax or spend and no international trade.
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