The five-sector circular flow model represents an open economy like Australia’s, and demonstrates the important relationships between the different sectors in the Australian market economy. It is the last circular flow model because it does not have any assumptions that need to be left out such as governments and trade. The five parts of the model: households, firms, finance, Government and overseas sectors work collectively to form the economy. The inter-relationships between these sectors create market economic conditions that affect every Australian.
The model of the economy demonstrates that it literally works as a flow or a cycle. It can the be further defined to include two flows, one, a flow of goods and services and the other, a flow of money. The flow diagram demonstrates that when one sector is at risk it puts economic market conditions in jeopardy because they are all reliant upon one another. The Australian Economy is open, which is its open to flows of goods, services and capital from overseas using different currencies (with fixed exchange rates). In the open economy income is used for consumption, savings, tax or spent on imports.
The new feature in the five-sector model is the overseas sector that includes imports and exports – Trade. The same principles apply to this model as the imports are represented as spending, however the money goes out of the economy. Money spent on imports by households or firms reduce income spent in the economy and are therefore classified as ‘leakages’ from the model. Imports can be categorised as the consumption of goods and services from the rest of the World and they reduce income, expenditure, output and employment from the Australian market economy. Importing goods mean that fewer Australian resources are utilised and production falls. Thus, the level of income decreases and the flow of money becomes smaller. Eventually however the flow would return to equilibrium but at a lesser rate and the circular flow would have contracted.
Furthermore, exports of goods and services generate income for exporters from overseas households or firms who pay for these exports. An Australian export is essentially a product or service that is produced here and sold to another country generating income for Australian businesses. Exports are therefore a form of injection of income into the circular flow without using Australian resources to produce them. With both imports and exports taking place as the new addition to the five-sector economy the circular flow is again complete. All income is consumed, saved, taxed and now can be used to purchase imports.
The economy is in equilibrium when income equals output equals expenditure or simply, Injections equal Leakages. The open economy will be in equilibrium when savings plus taxation plus imports equals investment plus Government spending plus exports. However, this does not mean that savings has to equal investment only that the total of S plus T plus M equals the total of I plus G plus X. However equilibrium is not necessarily a desirable or non-desirable thing.
Being at equilibrium is fine or at the point where savings, tax and imports are less than investments, Government spending and exports where this will cause a boom or expansion in economic activity however, being the opposite of this will cause a recession or contraction in economic activity. On a chart this is represented when the supply and demand curves intersect at the point where supply and demand are equal. The price at which the number of products that businesses are willing to supply equals the amount of products that consumers are willing to buy at a specific point in time.
Governments can stimulate or contract economic activity depending on the current state of the economy, world issues (including other economies around the world) and political matters. When the economy is at equilibrium they can choose to stimulate the economy by being at a point of budget deficit, which would increase spending, they can also do this by lowering taxes. If they want to reduce economic activity they can increase taxes, which may create political instability at the same time, or they can generate a point of budget surplus which would slow spending. Governments only have so much impact on the economy using this method. To have more influence and impact they produce some goods their self, they do this by owning large companies or shares in them such as Telstra and Australia Post which have a large amount of economic influence. Not only do these companies have a large amount of monetary influence every Australian relies on atleast one of their companies/services everyday.
The circular flow diagram can be used to analyse the position of the Australian economy. To do this you must first understand how the diagram works. The diagram flows in a cycle. Look at a point on the diagram and follow the arrows to see where it has come from and where it can go. Research economic current economic conditions in Australia and then see what affect this can have overall by looking at the sectors flowing to and away from it. Problems have an overall effect on every part of the circular flow model however, because if one thing goes wrong then it effects everything throughout the whole cycle until it returns to where it began.
The five sector circular flow model is very useful is helping to easily understand the way an open economy such as Australia works. It is a complete model including all possible sectors leaving nothing to assume. On a more careful analysis it even becomes possible to workout ways of stimulating and suppressing the economy using assumptions and simple equations. This model is especially helpful to students seeking an easy way to understand the way an open economy functions and the different affect certain problems can bring about.