Explain how Leakages and Injections Influence the Level of Economic Activity and Explain how the Government Influences Economic Activity By ahem Leakages and injections have a great influence on economic activity, as they basically are economic activity. Without leakages and injections there would be no circular flow, without which the economy would run as it does now. The government also plays a major role in the running of the economy as it has a great influence over what goes in and out of the circular flow by the way of taxation, imports and exports.
The five-sector circular flow of income model is a theoretical way for economists to scribe certain features of economic activity and the linkages between the main sectors. The circular flow model separates the economy into five sectors, a sector being a segment of the economy where the participants engage in a similar type of economic activity. The Australian economy has five main sectors: individuals, businesses, financial institutions, international trade and the government. The first and possibly most important sector is the individuals. It is concerned with the people’s spending of income on goods and services.
The economy would not operate as such without individuals as it is they who supply factors of production such as labor and business enterprise, which is used to produce goods and services. Business is another key sector consisting of firms engaged in producing and distributing goods and services. It is they who rely on individuals to supply the resources needed for the production process, as well as the consumption of goods and services. Financial institutions engage in the borrowing and lending of money including: credit unions, superannuating funds, building societies, life insurance companies and banks.
These institutions are required for people and businesses to save and invest. Savings are considered a leakage from the circular flow, as it is money that has been taken out from the flow. This results in a reduction in economic activity. When a person puts their income aside as savings, the balance of equilibrium is skewed as to the level of economic activity changes. If left to itself the leakage of savings will over time diminish the overall size of the would face a cycle of decreasing expenditure, falling production, lower income and higher unemployment rates until the economy collapsed.
To counteract this leakage, there is an injection of investment. For investment to occur savings are in fact necessary. Both saving and investing are needed for prosperity and growth in the economy, if the current consumption of goods and services is abandoned then it is possible to invest in capital goods. Thus improving the productive capacity of the economy in the future. This is what makes it possible to produce greater amounts of goods and services as the stock of productive resources is increased.
When a business invests it increases the demand for goods, this then stimulates production in the businesses that produce those goods, who as a result demand for more resources. Once the resources are increased, individuals’ incomes will also increase, stimulating yet another rise in the demand for consumer goods and services. Which then means greater levels of resource employment and so, higher incomes. Expenditure on investment basically results in more spending, higher rates of production, greater employment and levels of income in the economy.
The international trade and financial flows sector deals with money flowing in and out of Australia as injections and leakages or exports and imports. Other international transactions also include lending, borrowing and income movements. Imports are considered leakages, as they are goods and services that are produced overseas but sold in Australia, the money is taken from the Australian economy and paid to overseas firms. Any other money flows going outside of the country such as lending or paying income overseas is also considered a leakage.
On the other hand exports are goods and services that are produced in Australia and sold overseas. Any payments for exports are seen as injections into the economy as the money is coming into the country, not going out. This flow of income increases productions and stimulates employment opportunities within Australia. All inflow of none from overseas customers, foreign lending and paying income to Australians is considered an injection. The government sector can have significant influence over the economic choices of individuals and businesses including making it less or more expensive to make some choices.
An example being, for taxing an item such as cigarettes more heavily, the government attempts to stop people from smoking. Governments can seek to influence economic behavior by disallowing particular activities and imposing heavy penalties on anyone who breaks the law. Within the government sector there are three levels: federal, state and local. The education, roads and transport, health and defense. These of course require resources, which have to be obtained through imposing taxes on other sectors of the economy. Within the circular flow of income the government undertakes two significant roles.
One to impose taxes on firms and individuals, and number two, the tax revenue is used to undertake government expenditures. In the circular flow, taxation is considered a leakage because when a person pays income tax, this reduces the amount of money they have to spend on goods and services. This is where the majority of tax revenue comes from – individuals, but the overspent also taxes businesses. This reduces the money available for them to pay for resources, as a result taxation is a reduction in the level of economic activity, with falling levels of employment opportunities, decreasing income and output levels.
Government expenditure is an injection into the circular flow for two reasons. Firstly when the government spends money on collective goods and services, income is provided to government employees and those working for private companies from which goods and services are purchased. Secondly, the government uses part of it’s ax revenue to make transfer payments like pensions and unemployment benefits, which to it’s recipients at least, is considered income.
As a result government spending causes an increase in the level of economic activity with higher levels of employment opportunities, increasing income and output levels. The Australian government can manipulate the amounts of total leakages and injections having a major influence on the circular flow of income as levels of government revenue and taxation can be modified. As a result the government has the ability to offset any undesirable outcome from the inequality of investment.
The government can affect the ultimate result of injections and leakages through revenue collections and government spending. This has an overall impact on the level of economic activity. The government has the ability to either stimulate the economy by having greater injections and fewer leakages, or do the opposite by increasing the number of leakages in relation to injections. Overall the economy is made up of leakages and injections, which is all part of the circular flow. The major participants are the individuals, business firms, financial institutions, international trade and the government.