How an Economy works | Circular flow of income, Macroeconomics

In any economy, we have three economic agents that play a major role in a country’s economy, they are – Firms, government and household.

Let’s first understand the role of a firm. To understand this topic we are going to take an example of a capitalist country. In a capitalist country production activities are mainly carried out by capitalist enterprises. In other word we call them business tycoons like:- the Ambanis, the Tata’s, the Birla’s etc… Countries like Unite States, Canada, France, Germany they are a good example of a capitalist economy. In a typical capitalist enterprise there is one or several entrepreneurs. These people are mostly founders, CEOs, Chairman etc.

To run a firm, money is required, we call it capital. Sometimes you will use your own savings, your own money in the form of capital and supply it to run the enterprise, or you may borrow the capital from institutions like banks,  or other private financial investors in the form of loan with interest.

Now that you have sorted out the money part, you need to carry out production, basically make something. For that you will need natural resources. Some part of it will be consumed during production, because some percentage of raw material will be lost in making the final product, then there is another part which is going to be fixed, you will be needing a piece of land, electricity, water etc. These are necessary utilities and they are essential that’s why they are fixed.

Now you need another important element to carry out your production, basically human / manpower. We refer to this as labor. So far we have built three factors – capital, production and labor. After using all these 3 factors you will be producing something, we will refer to that as output.

Now you as a business owner you would like to sell the product in the market. The money that is earned by selling the product is called revenue. After earning revenue you will have to divide this revenue. Part of this revenue is paid for the services you have rendered like paying rent, electricity, water bill, repair and maintenance of your machineries etc. Another part of it is paid to capital as interest, remember the money you borrowed initially from banks and investors, you will have to return them with interest. Then another part of it will go to laborers as wages, you have to pay salaries to your employees. Now the rest of the revenue that is left is your earning, which we will refer to as profit.

Now this profit, is often used by the producers in the next period to buy new machinery or to build new factories, so that production can be expanded, we will refer to this as investment expenditure. So far this was the role of a firm in an economy. Now we will see the role of the government.

Apart from the private capitalist sector, there is an institution of State. We refer to this state as government. Now, the role of the government includes framing laws, enforcing them and delivering justice. Apart from this, govt also earns revenue by imposing taxes and then it spends that money on building public infrastructure, running schools, colleges, providing health services and many other social schemes. Therefore to understand the entire economy these economic functions of the government must also be considered along with the firms.

Apart from the firms and the government, there is another major agent that makes up the economy which is called the household sector. By household i mean a single individual or a group of individuals who takes decisions relating to their own consumption. Household consists of people like you and me. These people work in firms as workers and earn wages. These people are also the ones who work in the govt departments and earn salaries, they are also the owners of firms and earn profits. Since the household sector earns money as wage, they also spend, save and pay taxes. So one part goes to the govt, the other goes to the firm for buying their products and the remaining is saved. Hence we can also say the market and firms could not exist without the demand coming from the household.

So far we have described the major players that together makes an economy. now there is one more thing that we have to keep in mind and that is countries also engage in external trade. Basically dealing with export and import of goods and not just goods sometimes capital also comes in and goes out in the name of foreign investment. And that makes the 4th sector of an economy which is referred to as external sector. So this is how a country’s economy works. There is a complex interlink between the economic variables and it all comes under Macroeconomics.

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