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Macro Economy Flow Systems
Closed economy is an economy, in which no activity is conducted with outside economies. A closed economy is self-sufficient, meaning that no imports are brought in and no exports are sent out. The goal is to provide consumers with everything that they need from within the economy's borders (Investopedia, 2013). Closed economies are likely to have a lack of goods and resources, if they do not produce them themselves. In fact, there is no completely closed economies in the world. All countries have international economic relationships in the different scales (Investopedia, 2013).
Open economy is a market-economy mostly free from trade barriers and where exports and imports form a large percentage of the GDP (Business Dictionary, 2013). In the world, there are no absolutely open economies either. All of them have some trade restrictions, and governments control capital and labor movements. Degree of openness of an economic system determines a governments freedom to held economic policies of its choice, and the sensibility of the country to the global economic cycles (Business Dictionary, 2013).
All economies are dynamic systems. The economy is ''moving'', permanently operating. Economists have developed a model to show the way an economy works: the Circular Flow Model. The simplest type of it is called the two sector circular flow model. It is assumed that there are only two areas that are taken into consideration: the household sector and the business sector. The government sector and the overseas sector are not introduced. Therefore, such model represents a closed economic system (Interactive Economics, 2001).
The flows between firms and households are constant. Households sell economic resources (land, labor, and capital) to enterprises, and make payments for the goods and services that firms provide. Firms pay households for their resources, and receive payments for the goods and services from the households (Interactive Economics, 2001).
Within the model of the economy described above, there are two separate flows. The first flow is the outer one: economic resources are provided to the firms, which use them to produce goods and services. This flow is also defined as the real flow of resources and production. The second one is inner flow, or the money flow. Enterprises pay households for their resources, and households use this income to buy goods and services that firms produce. It can be called a money go round, in a sense. In such a model, households spend their wages on the goods produced by firms. Firms spend their money on the different resources from households. The total demand is always equal to total supply, total spending equals total production. The economy is always in equilibrium. For an open economy, flows are the same; however, injections and leakages are added (Interactive Economics, 2001).
In reality, households do not spend all money they have. Therefore, the initial model is expanded. First, saving is introduced. Households save part of their incomes in different financial institutions. The process of saving is defined as a leakage from the circular flow model. This is because the money is not spent by the households on goods and services produced by enterprises, and it reduces the velocity of the circular flow. Not all goods and services produced are immediately consumed. Investment is that part of production that is not consumed in the current period of time. Investment includes two components: changes in the level of capital used by the enterprise, and changes in the level of stocks and finished merchandise ready for sale. Investment is called an injection into the Circular Flow. Resources are used and paid during a period of time. The consumption of goods and services may occur during the next period; however, the money flow occurs today (Interactive Economics, 2001).
After that, government and overseas sectors are added to the model, and the model represents a real open economy. The government sector consists of all three layers of government: local, state, and federal. The governmental institutions impose different types of taxes and charges on the groups operating in the economy. Importers of goods pay tariffs (taxes levied on imports, not domestic goods). Taxation is also a leakage from the circular flow. The government uses the money from taxes to support different budgetary programs during the year. The government is responsible for a set of transfer payments to the disadvantaged groups of the society. It also spends money on the salaries of public servants. Government spending is an injection into the circular flow. High government spending usually increases economic activity (Interactive Economics, 2001).
The overseas sector is very important for the economy. Exports of goods and services are an injection into domestic economy, as the revenues received from export return to domestic (local) economy. Imports are a leakage from the circular flow, as the money used paid for imported goods and services moves overseas, and stops circulating within local economy (Interactive Economics, 2001).
A good example of leakage is a foreign investment, if it comes from domestic economy to another economy. The money leaves domestic circular flow. At the same time, foreign investments received by domestic economy are investments for it, because additional money enters its circular flow. Foreign investments act similarly to exports and imports.