CIRCULAR FLOW AND ITS EXPLANATIONS (DIAGRAM W/ THE GOVT INTERVENTION)

In the very.basic model, we have two principal components of the economy:

1.
2.

Firms. Companies who pay wages to workers and produce output.

Households. Individuals who consume goods and receive wages from firms.
This circular flow of income also shows the three different ways that National Income is
calculated.

1.
2.

National Output. Output produced by firms.

National Income. The total income received by people in the economy. For example,
firms have to pay workers to produce the output. Therefore income flows from firms to
households.

3.

National Expenditure. Total amount spent on goods and services. For example, with
wages from work, households can then buy goods produced by firms. Therefore, the spending
goes back to firms.
This represents a simple economic model; it is a closed economy without any government
intervention.
In the real world it is more complicated. We also add two more components:

1.

Government. The government taxes firms and consumers, and then spends money,
e.g. health care and education.
2.
Foreign sector. We sell exports abroad and buy imports. Therefore, there is a flow of
money between one country and the rest of the world.

GOVERNMENT FINANCE DEFINITION

Government finance is the deliberate manipulation of revenues and expenditures of the

government. It is the financial plan of the government. The government uses the different
types of revenues and expenditures as fiscal tools to achieve different objectives. The main
objectives are high economic growth, price stability, favorable balance of trade and payment,
equitable distribution of income and wealth, proper allocation of resources, balanced and
stable economic growth and so on. The government should avoid inflation and deflation,
recession or depression. Improper use of resources, price fluctuation, high inequality and so
on. For all these things revenues and expenditures are increased and decreased as per the
situation of the country.
Government finance has two sides, they are
1. Government revenues
2. Government expenditures
In government revenues, the money received by the government in the form of royalties,
taxes, escheats, penalties, fines, cess etc are included. In the government expenditure we
include development expenditure, administrative expenditures, diplomatic expenditure,
difference expenditure, payments of public debts and interest and miscellaneous expenditure.
They are used as fiscal tools to solve different economic problems.

GOVT TRANSFERS DEFINITION AND EXPLANATION W/ EXAMPLE

In economics, a transfer payment (or government transfer or simply transfer) is a redistribution of
income in the market system. These payments are considered to be non-exhaustive because they do not
directly absorb resources or create output. In other words, the transfer is made without any exchange of
goods or services.[1] Examples of certain transfer payments include welfare (financial aid), social security,
and government making subsidies for certain businesses (firms).
One-way payment of money for which no money, good, or service is received in exchange. Governments use
such payments as means of income redistribution by giving out money under social welfare programs such as social security, old
age or disability pensions, student grants, unemployment compensation, etc. Subsidies paid to exporters, farmers, manufacturers,
however, are not considered transfer payments. Transfer payments are excluded incomputing gross national product.

A transfer payment, from the standpoint of government finance, is a payment of money or in-kind benefit
(such as food stamps) that is given to individuals by the government without the government receiving any
goods or services in exchange. Transfer payments are not counted in calculating gross domestic product
(GDP) because they are not compensation received in exchange for goods or services. Instead, transfer
payments are considered a redistribution of income because the government uses revenue that it receives
from income taxation to make the transfer payments.
Examples:
a. government provision of roads.
b. government provision of national defense.
c. Social Security pensions.
d. government provision of education.

GOVT PURCHASE DEFINITION, EXPLANATION W/ EXAMPLES

Expenditures made in the private sector by all levels of government, such as when a government
entity contracts a construction company to build office space or pave highways.
Purchases made by the government from the private sector. In theory, government purchases are important to
the economy as contracts with the private sector often stimulate the economy when private companies are unable to do so.

FISCAL AND MONETARY POLICIES (DEFINITION W/ EXPLANATION AND EXAMPLES

Economic policy-makers are said to have two kinds of tools to influence a

country's economy: fiscal and monetary.
Fiscal policy relates to government spending and revenue collection. For
example, when demand is low in the economy, the government can step in
and increase its spending to stimulate demand. Or it can lower taxes to
increase disposable income for people as well as corporations.

Monetary policy relates to the supply of money, which is controlled via

factors such as interest rates and reserve requirements (CRR) for banks. For
example, to control high inflation, policy-makers (usually an independent
central bank) can raise interest rates thereby reducing money supply.
These methods are applicable in a market economy, but not in
a fascist,communist or socialist economy. John Maynard Keynes was a key
proponent of government action or intervention using these policy tools to
stimulate an economy during a recession.
COMPARISON CHART

Fiscal Policy
Fiscal policy is the use of
government expenditure and
revenue collection to influence
Definition
the economy.

Manipulating the level of

aggregate demand in the
economy to achieve economic
Principle
objectives of price stability, full
employment, and economic
growth.
Policy- Government (e.g. U.S.
maker Congress, Treasury Secretary)
Taxes; amount of government
Policy
spending
Tools

Monetary Policy
Monetary policy is the process by which the
monetary authority of a country controls the
supply of money, often targeting a rate of
interest to attain a set of objectives oriented
towards the growth and stability of the
economy.
Manipulating the supply of money to
influence outcomes like economic growth,
inflation, exchange rates with other
currencies and unemployment.

Central Bank (e.g. U.S. Federal Reserve or

European Central Bank)
Interest rates; reserve requirements;
currency peg; discount window; quantitative
easing; open market operations; signalling

Policy-makers use fiscal tools to manipulate demand in the economy. For example:

Taxes: If demand is low, the government can decrease taxes. This increases
disposable income, thereby stimulating demand.

Spending: If inflation is high, the government can reduce its spending thereby
removing itself from competing for resources in the market (both goods and services).
This is a contractionary policy that would lower prices. Conversely, when there is a
recession and aggregate demand is flagging, increased government spending in
infrastructure projects would lead to higher demand and employment.
Both tools affect the fiscal position of the government i.e. the budget deficit goes up
whether the government increases spending or lowers taxes. This deficit is financed by
debt; the government borrows money to cover the shortfall in its budget.
Examples of monetary policy tools include:

Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of
money. By manipulating interest rates, the central bank can make it easier or harder to
borrow money. When money is cheap, there is more borrowing and more economic
activity. For example, businesses find that projects that are not viable if they have to
borrow money at 5% are viable when the rate is only 2%. Lower rates also
disincentivize saving and induce people to spend their money rather than save it
because they get so little return on their savings.
Reserve requirement: Banks are required to hold a certain percentage (cash
reserve ratio, or CRR) of their deposits in reserve in order to ensure that they always
have enough cash to meet withdrawal requests of their depositors. Not all depositors
are likely to withdraw their money simultaneously. So the CRR is usually around 10%,
which means banks are free to lend the remaining 90%. By changing the CRR
requirement for banks, the Fed can control the amount of lending in the economy, and
therefore the money supply.

Currency peg: Weak economies can decide to peg their currency against a
stronger currency. This tool is usually used in cases of runaway inflation when other
means to control it are not working.

Open market operations: The Fed can create money out of thin air and inject it
into the economy by buying government bonds (e.g. treasuries). This raises the level of
government debt, increases the money supply and devalues the currency causing
inflation. However, the resulting inflation supports asset prices such as real estate and
stocks.