Five sector model of the australian economy
Economic activity can also be depicted via a five sector model of an economy. It is similar to figures 5.2 and 5.3, except it includes reference to five key sectors in the economy that connect all of the flows.
The flows of production, income and consumption occur as a result of transactions between the Business and Household sectors. The household sector provides the Business sector with resources (such as labour) and this is highlighted by Flow 1 in the diagram. In return, the business sector provides the Household sector with income (such as wages), which is highlighted by Flow 2. Part of this income is then consumed via the purchase of goods and services (i.e. Consumption), which forms part of Flow 3. However, part of the income earned by households does not immediately result in the consumption of Australian goods and services because the income is diverted through the Financial, Government and External sectors in the following three ways:
Part of household income is saved in the Financial sector (e.g. put into bank accounts), who then ultimately lend the money back to other households or businesses. The money ends up being spent either in the form of Investment or Consumption.
[Notice that the dashed purple line leading back to Consumption represents that portion of Savings that is not spent on Investment goods, but instead is used for the purchase of all sorts of ‘consumption’ goods and services, such as whitegoods, clothes, holidays, etc. It includes the bulk of expenditure that is spent via the use of credit cards.]
Part of household income is taken by the Government sector in taxes, but it too ultimately finds its way back into AD either via Government demand (such as spending on infrastructure) or via Consumption once welfare recipients (such as pensioners) spend government transfers.
[Notice that the dashed purple line leading back to Consumption represents that portion of Taxes that is not spent by governments on goods and services, but instead is spent by those in receipt of transfer payments (such as job search allowance, family benefits and pensions.]
Finally, part of household income is spent on foreign goods and services (i.e. imports), which detracts from AD given that it does not represent demand for goods and services that are produced by Australia’s Business Sector. But as discussed earlier, this is at least partially offset by foreign demand for Australian goods and services (i.e. exports).
Overall, the total demand placed on Australia’s Business sector is made up of AD (Flow 3) which then determines the total real value of production in the economy (i.e. Flow 4).
The use of the model is illustrative because it helps us to gain a better understanding of the influences affecting AD and economic activity. For example, it should be apparent that any decision by the Household sector to increase their rate of Savings (e.g. because householders have lost confidence in the economy) will tend to reduce the growth of AD and economic activity unless the Business sector is immediately willing to increase Investment spending by the same amount. If the Business sector are also experiencing low confidence levels then an equivalent amount of Investment is unlikely to occur, even in spite of a fall in interest rates that should occur when savings increase. Similarly, a decision by the Government sector to raise Taxes without any corresponding increase in Government spending (i.e. increase budget surpluses) should also act as a further constraint on AD and economic activity. With respect to the External sector, a decrease in the international competitiveness of Australian exporters and import competing producers should also serve to constrain AD as Australians will tend to purchase more imports (rather than local products) and foreigners will tend to purchase exports from Australian competitors (such as New Zealand).