Circular flow of income: two-sector model

Correct answer: C. Leakage and injection are equal

Explanation: In a simple two-sector economy, households divide income between consumption and saving, while firms undertake investment. Saving is treated as a leakage from the circular flow, and investment is treated as an injection into it. Here S = 20 and I = 20, so the leakage exactly equals the injection. This indicates balance in the flow, not a conclusion about the government budget.

Correct answer: B. Leakage is greater than injection

Explanation: In the two-sector model, saving represents a leakage because it withdraws purchasing power from the current circular flow. Investment represents an injection because it adds expenditure back into the flow. Since S = 30 and I = 18, leakage exceeds injection by 12 units. Therefore, the correct statement is that leakage is greater than injection; the model does not justify a conclusion about exports.

Correct answer: C. Expansionary pressure

Explanation: Saving is a leakage from the circular flow, while investment is an injection into it. Here investment is 35 and saving is only 15, so injections exceed leakages by 20 units. This additional spending can raise aggregate demand and encourage higher output and income, creating expansionary pressure in the short run. The result is not a tax or foreign-payment conclusion.

Correct answer: B. There are no transactions with the foreign sector

Explanation: A closed economy is defined by the absence of economic transactions with the foreign sector. Therefore, exports and imports are excluded from its basic circular-flow model. The two-sector model usually contains only households and firms; it does not include foreign trade, government transactions, or a separate external sector. Hence option B is the only precise identification, whereas high exports, government spending, and bank lending are not defining conditions of a closed economy.

Correct answer: A. It incorrectly includes the government and foreign sectors

Explanation: In the basic two-sector model, only households and firms are considered. Saving is the principal leakage from the household-firm circular flow, while investment is the corresponding injection by firms. Taxes belong to a model that includes the government sector, and exports belong to a model that includes the foreign sector. Thus, describing tax and exports as the main two-sector flows incorrectly adds both omitted sectors, making option A correct.

Correct answer: A. Factor demand is derived from product demand

Explanation: Firms demand labour, land, capital, and entrepreneurship because these factors help them produce goods and services that they expect to sell. The demand for factors is therefore derived from the demand for the final products they help create. If product demand rises, firms may expand production and employ more factors, subject to costs and capacity. Taxes, imports, and exports are not the basic relationship being tested in the two-sector model. Hence option A is correct.

Correct answer: C. Factor income

Explanation: In the two-sector model, households own or supply the factors of production, including labour, land, capital, and entrepreneurial ability. Firms hire these services and pay wages, rent, interest, and profits. These payments constitute household factor income and provide the purchasing power used to buy goods and services from firms. Foreign aid, government grants, and import gains require sectors or transactions outside the basic household-firm model, so option C is correct.

Correct answer: B. Wages and interest

Explanation: In the two-sector circular flow model, households own and supply factors of production to firms. Labour receives wages as its factor reward, while capital receives interest. Therefore, when both labour and capital services are supplied, the corresponding money flow from firms to households is wages and interest. Rent rewards land and profit rewards entrepreneurship.

Correct answer: B. Rent and profit

Explanation: Land and entrepreneurship are two factors of production supplied by households. The factor reward for the use of land is rent, while the reward for organising production and bearing business risk is profit. Thus, the correct pair of factor incomes is rent and profit. Wages belong to labour and interest belongs to capital.

Correct answer: A. Total planned expenditure may remain unchanged

Explanation: In a two-sector model, planned expenditure is represented by consumption plus investment: PE = C + I. If consumption decreases by 10 units and investment increases by 10 units, the changes cancel each other. Consequently, the level of total planned expenditure may remain unchanged, assuming no other component changes. Government spending and exports are not components of this model.

Correct answer: B. Decrease by 5 units

Explanation: For a two-sector economy, total planned expenditure is PE = C + I. The change in consumption is −10 units and the change in investment is +5 units. Adding the changes gives −10 + 5 = −5 units. Therefore, total planned expenditure decreases by 5 units. The calculation concerns the net change, not the sum of absolute values.

Correct answer: C. No net change

Explanation: Total planned expenditure in the two-sector model equals consumption expenditure plus investment: PE = C + I. The increase in consumption is +12 units, while the decrease in investment is −12 units. Their combined change is +12 − 12 = 0. Hence, the total planned expenditure experiences no net change, although its individual components change.

Correct answer: A. Households providing labour, land, capital and entrepreneurial services to firms

Explanation: A real flow refers to the physical movement of goods, services or factor services rather than money. In the two-sector model, households supply labour, land, capital and entrepreneurial services to firms. Firms send factor payments such as wages, rent, interest and profit in the opposite direction as money flow. Therefore, option A is correct.

Correct answer: A. Government purchase of goods and services from firms

Explanation: The two-sector circular flow model contains only two sectors: households and firms. Household consumption and firms’ sales of final goods occur in the product market, while firms’ factor payments to households occur in the factor market. Government purchases require a government sector and therefore belong to a three-sector model, not the basic two-sector model.

Correct answer: B. Unplanned inventories may rise

Explanation: When households save more than they had planned, they spend a smaller share of their income on consumption. If firms have already produced goods on the basis of higher expected demand, actual sales will be lower than expected. The unsold goods accumulate in firms’ inventories, creating an unplanned inventory increase. This is a short-run disequilibrium signal, not a necessary permanent result. Option A would be more consistent with unexpectedly strong consumption demand, while options C and D incorrectly assume that inventories cannot respond or must disappear.

Correct answer: A. They may decide to reduce output

Explanation: Rising unplanned inventories mean that firms are producing more than buyers are purchasing at the current level of output. Unsold goods are accumulating, which indicates that actual expenditure is below the value of current production. To prevent further accumulation and bring production closer to demand, firms may reduce output in the next period. The adjustment can also affect employment and income. Increasing output or deliberately adding more stock would generally intensify the disequilibrium rather than correct it.

Correct answer: A. Demand for the product is higher than expected

Explanation: A faster-than-expected fall in inventories usually means that firms are selling goods more quickly than they anticipated. Thus, actual demand is exceeding the demand used in their production plans. If this pattern continues, firms may interpret it as a signal to raise output, order more inputs, or employ more factor services. The result is not caused automatically by saving, taxation, or imports in the basic two-sector model, because that model contains only households and firms and excludes the government and foreign sector.

Correct answer: A. Demand for factor services may rise

Explanation: When product demand is unexpectedly strong, firms may try to increase production so that they can sell more goods and avoid losing customers. Higher production generally requires additional labour, land, capital, or entrepreneurial services, depending on the production process. Therefore, demand for factor services may rise in the factor market. This can increase factor payments and household income, completing an important link in the circular flow. Taxes and exports are outside the basic two-sector model, and factor demand does not become zero merely because product demand is high.

Correct answer: A. A leakage from the circular flow of income

Explanation: In the basic two-sector model, households receive income from firms and divide it between consumption and saving. Saving is not immediately spent on currently produced goods, so it withdraws purchasing power from the income stream and is called a leakage. Investment by firms is an injection because it adds expenditure. Therefore, option A is correct.

Correct answer: A. Factors of production, such as labour and land

Explanation: The real flow records physical movements rather than monetary payments. Households own or supply factors of production—labour, land, capital and entrepreneurship—to firms, which use them to produce goods and services. Consumption expenditure and factor income are money flows, not real flows. Direct taxes are associated with the government sector. Hence, option A is correct.

Correct answer: A. Factor income

Explanation: Households provide labour, land, capital and entrepreneurship to firms. The payments received for these services are wages, rent, interest and profit, collectively called factor income or factor payments. Consumption expenditure is spending by households on goods and services, investment is generally firms’ spending on capital goods, and transfer payments are made without a current factor service. Thus, A is correct.

Correct answer: A. Demand is lower than expected

Explanation: Unplanned inventories rise when firms produce more than they sell at the prevailing level of demand. The unsold output accumulates as stock, showing that actual demand is weaker than firms expected. This is a signal of deficient demand in the simple two-sector model. A fall in unplanned inventories would indicate sales exceeding expected output. Therefore, option A is correct.

Correct answer: B. Demand may be higher than expected

Explanation: A fall in unplanned inventories means that firms sold more goods than they had anticipated, so actual demand was higher than expected. The unexpected sales reduce stocks of finished goods. Firms may respond by increasing production and planned inventories in the next period. Therefore, option B is correct; the other options do not describe inventory depletion.

Correct answer: B. Leakage from the money flow

Explanation: Household saving is the part of income that is not spent on currently produced goods and services. Consequently, it reduces the stream of consumption expenditure moving from households to firms, which is the monetary flow. It is therefore a leakage from the money flow. In the basic two-sector model, investment is the corresponding injection.

Correct answer: D. 5

Explanation: In the simple two-sector model, the economy consists of households and firms, and the multiplier is calculated as k = 1/(1 − MPC). Since MPC = 0.8, the marginal propensity to save is MPS = 1 − 0.8 = 0.2. Therefore, k = 1/0.2 = 5. Hence, option D is correct. The value 0.2 represents MPS, not the income multiplier.