Question

With respect to the three sector model of the circular flow of income with the government sector which of the following are included as leakages?

• A. Savings
• B. Taxes
• C. Imports
• D. All of the above

Answer 1

Answer: (D)

All of the above

The three sector model of circular flow involves three groups, i.e. the households, firms and the government. Addition of the government increases complexity of interactions by introducing leakages and injections.
Taxes and government spending are connected through the government. Households pay taxes to the government; this is a leakage because it is income that is not spent to buy goods and services. The government uses the tax to finance government expenditures (on education, health, defence, etc.) and this is an injection back into expenditure flow.
Savings by households represents a leakage again because it is income that is not spent to buy goods and services. Households place the savings in financial markets (bank accounts, purchases of stocks and bonds, etc.). Firms get the funds from financial markets (through borrowing, issuing stocks and bonds, etc.) to finance investment or production of capital goods. These funds, therefore, flow back into the expenditure flow as injections.

Imports are goods and services produced in other countries and purchased by domestic buyers. Exports are goods and services produced domestically and purchased by foreigners. Imports and exports are linked together through other countries. Imports are a leakage because they represent household spending that leaks out as payments to the other countries that produced the goods and services. Exports are an injection because they are spending by foreigners who buy goods and services produced by the domestic firms.