QUESTION

The question:  With reference to the ‘Circular Flow of Income’ model discuss the impact on their respective economies of i) EU austerity measures (higher taxes and lower public spending) and ii) of China’s public works spending and control over bank lending.

PLEASE NOTE;

it must have an introduction stating the scope of the discussion,
paragraphs that focus on specific building blocks of the discussion, and a
conclusion that is based on the discussion and directly relates back to the subject of the discussion.

The discussion must be supported by examples and references cited in the text.
A list of references must be provided at the end, which must cite predominantly book/journal articles and authoritative sources.
SOLUTION

INTRODUCTION

In operation Level economics (OLE) (Punabantu, 2010), the Law of Conservation (LCR) clearly explains that all the resources, be it financial or monetary resources, can neither be created nor be destroyed. This particular condition is called as ZERO GROWTH in Operating Level of Economics (OLE). This particular law of   business and economics gives rise to application of “Circular Flow of Income ((CFI) which is currently functional in all the economies which is totally linear in pattern.

CFI being linear, so it inherently incapable of showing any kind of economic growth in economy. SO the fundamentals related to the contemporary economics are based on another theory called Scarce Resource Theory (SRT).

CIRCULAR FLOW OF INCOME

The Circular Flow of Income divides the economy into five sectors and then describes the operation of this economy and the links existing between these five main sectors in the economy (Enoch, 2002).

A sector can be called the part of the economy where all the members are engaged in same type of economic activity. Below listed are the five sectors of economy which are present in Circular Flow of Income:

• Individuals
• Financial Institutions
• International trade
• Businesses
• Government

The diagram shown below depicts the Circular Flow of Income in the economy:

INCOME REWARDS

EXPENDITURE ON GOODS & SERVICES

SAVINGS                                                                               INVESTMENT

TAXATION                                                                             EXPENDITURE

IMPORTS                                                                                 EXPORTS

Fig 1: Circular Flow of Income

SCOPE OF DISCUSSION

It has been seen that countries are linked through these flows all across the national borders of not just the goods and services but also labour, financial capital and information as well. None of the countries exist in isolation that is why due to these linkages the problems of one country get transmitted to the other countries too.

Suring the crisis which occurred in 2008 there have been three channels of spillovers which are being analysed which led to spillover of recession from United State to the rest of the world. The three spillover channels in the circular flow of income are listed below:

• Contagious effect which occurred due to the market psychology.
• Across eth borders of nations spillover happened within the financial markets due to the integration of financial markets especially in case of European Union.
• The spillover occurred from financial markets into the real markets in the U.S. which was simultaneously followed by spillovers in real-time to other countries across the globe.

The diagram shown below depicts how the spillover occurred in the rest of the countries form United States and the diagram shows the interaction between one country and rest of the world where the interaction happened or became operational through the flow of services, goods and financial assets.

During the good times these interactions help in the right working of the world economy, but during bad times, like financial crisis in U.S., these same links are responsible for sharing these financial crisis.

Consumption                                                                                       Consume                                                                                                                                     -ption +                                                                                                                                     Net export

Borrowings from

Other countries

Imports

Exports

Figure 2: Foreign Sector in Circular Flow of Income

The three International Flows shown in above figure are:

• Exports
• Imports
• Financial Flows

IMPACT OF CIRCULAR FLOW OF INCOME ON EU AUSTERITY MEASURES

The circular flow of Income works on a system which is created to prevent growth which is quite evident from the Fischer Equation (MV=PT) and the linkages it has to the monetary policy. In order to achieve efficiency and stability, the market system tries to achieve the objectives of financial system thus indirectly reinforcing the zero growth position which leads to prolonging of economic scarcity in the country. This is what is happening in the case of European Union (EU) too.

According to contemporary economics where the human life stands totally in conflict with the scarce resources in order to sustain people, encourage the belief that achieving the resources is more important and making them available is more important than human beings.

This is what happened in case of implementation of austerity measures which were introduced in Europe in order to restore the budget deficits. Portuguese will have to pay maximum VAT ( value-added tax) rates in the whole Euro zone as per government rules , whereas the wages of civil servants will be slashed by 10% from 2011 onwards (“Taxes up, wages down”, 2010).

At the same time austerity measures that is higher taxes and lower income spending hit Romania which is also recession-hit, have made the government unpopular although it has received 20 billion euro aid-packages from International Monetary Fund. Thus the country government is facing a no confidence vote in parliament and around 10,000 protestors marching outside government headquarters in Bucharest (Romania, 2010).

The main idea out here is that the Contemporary Economics (CE) needs to convince that the resources are perpetually scarce as per Scarce Resources Theory (SRT). Due to SRT only the government’s face budget deficit and they need to cut back on the public spending. Due to scarcity of resources something has to be forgone like jobs, activities depending on public spending, if the government has to achieve “something” like lower budget deficit.

The modern day CFI is unable to generate the economic resources as desired by the human needs and governmental requirements, not because it is not capable of doing so but it is not calibrated to do so. To change this scenario the psychology of people in economy needs to change and they need to accept limitations and scarcity as necessary evils.

IMPACT OF CIRCULAR FLOW OF INCOME ON CHINA’S PUBLIC WORK SPENDING AND CONTROL OVER BANK LENDING

China also got impacted due to the financial crisis because of its trade linkages, as it exports lot of goods to the western countries. Because of slowing down of economic activities in the western countries the demand for services as well as goods manufactured by China also decreased. This caused big time m decrease in real GDP of China. As depicted in the Figure 2 above decrease in the exports by China caused the decrease in output from the Chinese companies. This reduced the income of the Chinese households too and the lower spending through eth application of multiplier process.

Although China was owner of many assets in US maximum of these assets were not related to the mortgage-backed securities. Rather the Chinese were holding approximately $900 billion in US Treasury Securities. Thus although the securities values changed when the financial situation changed, it just led to change in the value of the portfolios but did not cause the bankruptcy of the financial institutions in China.

The main reason behind the financial institutions not going bankrupt was in China the maximum number of banks are owned by government whereas in Europe and U.S. it is not so, most of the banks are private. The topmost state-owned banks in China covered almost 66% markets of deposit in China in 2007. Thus of there is decrease in the value of assets of these banks, it will show up in the budget of the government. But in case of governments of United States and U.K., the crisis of 2008 was being confronted by partial nationalisation. Some of eth shares of the banks were being purchased by the government, but it was pointless in case of China because the government already has considerable ownership in the banks.

Thus the lacunas of circular flow of income do not have much effect on Chinese economy because China already has control over bank lending. AT the same time the GDP of China is much higher than Canada, but when we analyse the GDP on per capita basis for china it has been found that it is much lower than Canada. The reason being the population of China is more than 1.3 billion people, while Canada just has 30 million people in total population.

So in case of China the Public work spending has to be more because of the large population it has, although the GDP of China is very high. Since the number of households is very high, the expenditures on the goods and services will be much higher (Dorton, 2007). Thus the equilibrium in the circular flow of income is hard to maintain in Chinese economy. The equilibrium can only be maintained when:

SO if the leakages increase in the economy without there being corresponding rise in injections, the national output is bound to fall and achieve a new equilibrium (Baxendale, 2011). This happens because there will be lesser income which can be circulated. The same is applicable vice-versa too.

Thus it can be seen that circular flow of income has both positive and negative impact on the Chinese economy.

CONCLUSION

Fiscal stimulus is the best tool which governments can use to enhance the level of economic activity whenever the economy suffers from recession. The two best ways which the governments can use as fiscal stimulus that is either it can tweak the tax system like EU is by incorporating the austerity measures which will enhance the incentives which eth government can spend and work or the second way is it can increase the government spending . Since the Chinese economy has introduces the public work spending measures and EU introduced the austerity measures where EU increased the amount of VAT taxes in Portugal etc. it has to experience opposition from public. Whereas the Chinese economy is not getting much affected in case of financial institutions like banks because the government already has extensive share in the banking sector.

Bibliography

‘“Taxes up, wages down”’, POrtugal News Online (1 October 2010).

Baxendale, T. (2011) The circular flow of income fallacy , 23 October, [Online], Available: http://www.cobdencentre.org/2011/10/the-circular-flow-of-income-fallacy/ [21 May 2012].

Dorton, B.&. (2007) ‘MACROECONOMICS : Measuring National INcome’, Economics – A Course Companion, pp. 147-157.

Enoch, L. (2002) Circular flow of income, December, [Online], Available: http://intrepix.tripod.com/ [21 May 2012].

Punabantu, S. (2010) The Greater Poverty & Wealth of Nations: An Introduction to Operating Level Economics.How every economy has the latent financial resources with which to finance the doubling of its GDP in one year at constant price, Lusaka: ASG Advisory Services Group.

‘Romania’, Balkans.com (23 September 2010).

LE11

But you can order it from our service and receive complete high-quality custom paper.  Our service offers Economics  essay sample that was written by professional writer. If you like one, you have an opportunity to buy a similar paper. Any of the academic papers will be written from scratch, according to all customers’ specifications, expectations and highest standards.”