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Economics Concepts and Reflection 

Circular Flow of Income

The recurring demand and unlimited wants of the people make the production process a continuous process. In the production process, different factors of production like land, labour, capital and enterprise are used to produce the final goods and services. The production sector requires factor of services that is provided by the household sector. Thus, the production sector takes the factor services from the household sector for the production of goods and services. In return, the production sector provides factor payments like rent, wages, interest and profits to the household sector (Mao et al., 2018). The households purchase goods and services from the money provided. I could understand that all this demand and supply of goods actually leads to flow of goods and income between different sectors of economy. Such a flow of income is referred as circular flow of income.

The above is the diagram showing phases of the circular flow of income. In the production phase, firms produce goods and services using the factor services. This phase leads to the other phase of generation of income. In this, the household receives their factor incomes. Thus, the value addition is converted to monetary value in this phase. The last phase of the circular flow of income is the phase of disposition. The income earned by the households is spent on the goods and services in this expenditure phase. This creates further demand of the goods and services which creates pressure on the production sector to increase the production. Thus, this cycle of flow of income continues and hence, it is called circular.

This circularity never stops because there is always discovery of new resources and innovative technology in the production sector. The circular flows are of two types. One is the real flow and other is the money flow. Real flow refers to the movement of factor goods and services from firms to households and movement of factor services from households to firms. Whereas, money flow refers to the flow of factor payments from firms to households and at the same time, the flow of expenditure from households to firms.

GDP And Economic Models

Gross Domestic Product (GDP) is a term which we come across very often if we read newspaper. It is a measure of well being for the country. Gross Domestic Product refers to the gross total value of final goods and services produced in the domestic territory in an accounting period (Trinh et al., 2017). In other words, it refers to the aggregation of consumption by households, investment by firms, government purchases and net exports of goods and services.

Nominal Gross Domestic Product refers to the gross value of goods and services produced in the domestic territory of a country, in an accounting period, calculated at current year prices. Whereas, Real Gross Domestic Product refers to the value of goods and services produced in the domestic territory of the country in an accounting period, calculated at constant year prices or base year prices. Real GDP is considered as the indicator of economic welfare or growth.

Gross domestic product can be measured using several methods. One of them is value added method, also known as net output method. In this method, value added which is addition to the value of output excluding intermediate consumption are added of all the sectors, i.e. primary, secondary and tertiary sector. The other method is called income method. In this method, all the factor payments like rent, wages, interest and profits made by the production sector are added to get to the national income. The third method is expenditure method. Here, all the expenditures incurred by households, firms, government and foreigners on the goods and services are added up to get the gross domestic product. From all the three methods, we come to the same national income.

According to me, one of my important learning from the article was that GDP is often considered as an index of welfare, but there are some limitations to this generalisation. As we notice, there are lot of innovations and rapid rise in the level of technology which implies that the economy is growing. However, the measured productivity is disappointing. This means there is some problem in the measurement method. Also, with the rise in GDP, there are chances that the inequities in the distribution of income also raise. The gap between the rich and poor can be widened. Then, it is possible that GDP is not capturing the welfare of the economy. Even, the non monetary activities such as household chores, gardening are not included in GDP.

Fiscal Policy

Fiscal policy refers to the taxation and expenditure policy of the government. This is done to control the excess demand and deficient demand in the economy. In other words, it is the policy of the central government which they use to control the money supply in the economy. It is also known as ‘Revenue and Expenditure Policy' of the government (Bianchi & Ilut, 2017) Through this policy, the central government has an influence on the economic activities of the economy and uses it to stabilise the economy. The different macro variables which are affected by this fiscal policy are aggregate demand, savings and investment, income distribution and the allocation of resources.

There are two types of fiscal policy. One is, expansionary fiscal policy and the other is, contractionary fiscal policy. The government can use any of these depending on the situation of the economy.

Through the article, I could understand the relationship between present demand and choice of policy adopted by the government. When there is deficient demand in the country, then the aggregate demand is less than the aggregate supply. In this case, the central government can use expansionary fiscal policy to increase the aggregate demand in the economy. There are various instruments which are used to control deficient demand. Some of them are taxes, government spending, public borrowings and deficit financing. Here, the government can increase the government spending. It can do so by expenditure on public works like construction of roads, bridges, buildings etc. This will lead to an increase in money supply which raises the level if aggregate demand. The other way to control deficient demand is to decrease the taxes imposed. This increases the purchasing power of the consumers and their real income rises, leading to rise in aggregate demand. Also, the government can reduce public borrowings and refund the earlier borrowings.

In the case of excess demand in the economy, the government should use contractionary fiscal policy to curb the demand of people. It can increase the taxes which lead to fall in the real income of the people. Also, the government can reduce the public expenditure to control the excess demand.

Monetary Policy

Monetary policy refers to the policy of the central bank of the country to control the level of money supply in the economy. This is the policy to control the economic activities in a country. Since central bank is an apex body who controls and supervises all the other banks, it has the sole authority to control the money supply and credit in the market.

There are two types of monetary policy: expansionary monetary policy and contractionary monetary policy. The central bank according to the economic fluctuations in the market uses the required policy measure to stabilise the economy.

Expansionary monetary policy refers to the policy aimed to increase the money supply in the economy by the central bank. This is used when there is recession in the economy and the aggregate demand is less than aggregate supply. There are various methods of credit control. Bank rate is one of the them (Cúrdia & Woodford, 2016). The central bank can decrease the bank rate. If this happens, then the commercial banks will decrease their interest rate. This will make credit less costlier. It encourages the borrowers to borrow money from the bank which leads to increase in the supply of money in the economy. Central bank can also use repo rate or reserve repo rate to increase the money supply. Open market operations can be used by the central bank. It refers to the buying and selling of government securities by the central bank to control the money supply in the economy.

Contractionary monetary policy refers to the policy aimed to decrease the money supply in the economy. The central bank can increase the bank rate, repo rate to decrease the money supply in the economy by making credit costlier to the people. Legal reserve requirement like cash reserve ratio and statutory liquidity ratio can also be used to control the money supply. These are the very quick methods to control the money supply.

Foreign Exchange and Balance of Payments

Foreign exchange is defined as foreign currencies. It includes all the currencies except the domestic currency of a given country. For example, India’s domestic currency is Indian Rupee while US dollar, British pound, Thailand baht etc. are foreign exchange.

For the exchange of goods between the countries, foreign exchange is required. Thus, there is a foreign exchange rate which refers to rate at which one currency is exchange for the other.

I understood that it is important to maintain records when there is an exchange of goods and services between the countries (Obstfeld & Taylor, 2017). The government maintains a record of all these transactions between the country and rest of the world. This record is called as Balance of Payments. This Balance of Payments is a summary statement of all the economic transactions made between the residents of the country and rest of the world, in a given period. Since, it is related to a given period of time, it is a flow concept.

Like a typical business, BOP accounting uses the ‘Double Entry System'. In this system, there are two sides in which the transactions with the rest of the world are recorded. In the credit side, all the inflows of foreign exchange are recorded while in the debit side, all the outflows of foreign exchange are recorded.

In reality, the BOP is not always equal. There can be cases of surplus, deficit or balanced BOP. In surplus BOP, receipts of foreign exchange exceeds the payments of foreign exchange and vice- versa in the case if deficit BOP. While in the balanced BOP, receipts of foreign exchange are equal to the payments of foreign exchange.

The three main components of BOP are: Current account, Capital account and Financial account. Current account captures all the transactions related to exports and imports of goods and services and unilateral transfers during a particular time period. Capital account records all the transactions which cause a change in assets and liabilities of the country. Financial account records all the flows related to investment in businesses, real estate and stocks between the country and the rest of the world. BOP is very helpful for the economy and is an integral part of international financial management.


Mao, J., Li, C., Pei, Y., & Xu, L. (2018). Value Flow of a Circular Economy. In Circular Economy and Sustainable Development Enterprises (pp. 127-149). Springer, Singapore.

Trinh, T. H. (2017). A primer on GDP and economic growth. International Journal of Economic Research, 14(5), 13-24.

Bianchi, F., & Ilut, C. (2017). Monetary/fiscal policy mix and agents' beliefs. Review of economic Dynamics, 26, 113-139.

Cúrdia, V., & Woodford, M. (2016). Credit frictions and optimal monetary policy. Journal of Monetary Economics, 84, 30-65.

Obstfeld, M., & Taylor, A. M. (2017). International monetary relations: Taking finance seriously. Journal of Economic Perspectives, 31(3), 3-28.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Economics Assignment Help

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