How Economies

Operate 2
Multiple Choice
1 D 6 A 11 D*
2 B* 7 D 12 B
3 C 8 B 13 A
4 A 9 C* 14 C
5 C 10 B* 15 D*
*Indicates that an enhanced answer has been provided in the section below.

Enhanced Answers
2 B Low investment levels correspond with fewer injections into the economy, contributing to
lower potential output. Many businesses rely on investment for the purchase of capital goods
that in turn increase output. Therefore, a decline in investment reduces the ability of firms to
innovate and grow, leading to decreased production and ultimately lower total output.

9 C Although both tax revenue and government expenditure increase from Year 1 to Year 2, tax
increases more. All things being equal, leakages will therefore outweigh injections, reducing
economic activity.

10 B The government can decrease the level of economic activity in an economy by increasing tax
rates. This has the effect of removing money from households who and business who may
otherwise consume or invest, increasing the leakages in the circular flow of income and
dampening economic activity.

11 D Because markets do not always produce fair and equitable outcomes for everyone, the
government may decide to intervene in the economy to create a more equal distribution of
income to redistribute income from those who earn the most to those who earn the least.

15 D Financial institutions are the intermediaries between savers and borrowers of money. They
form the capital market and are comprised of banks, credit unions, finance corporations,
insurance companies and superannuation funds. Their main role is to facilitate the process of
saving and investment and typically consumers hold more savings than businesses, while
businesses borrow more money (for capital) than consumers.

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 The Market Economy Eighth Edition Workbook  Chapter 2: How Economies Operate

Short Answers
Question 1

(a) Equilibrium occurs when the sum of all leakages equaling the sum of injections in the circular
flow of income.

(b) Education levels affect skills levels and the productivity of labour and so affect wages, with
higher educational qualifications associated with higher wages. The general level of economic
activity also affects wages because the fewer people available for each job, the tighter the
labour market and the more likely that wages will rise (and vice versa).

(c) Increased incomes mean that disposable incomes for households are higher, allowing them to
spend more on consumption. As businesses produce to meet consumer demands, higher
incomes mean more goods and services will be purchased, leading businesses to increase
production. This requires firms to increase factors of production such as labour, and as stated
in the RBA minutes, this is likely to lead to a lowering in the level of unemployment.

(d) The government collects taxes from individuals and businesses, although it is usually simplified
as coming from the household sector in the circular flow model. Tax is a leakage because it
takes money away from households who may otherwise spend it on consumption.
Governments spend tax revenue on a range of items including infrastructure and welfare
payments which are an injection. If the economy is in disequilibrium with leakages lower than
injections, the government can increase tax to restore the economy to equilibrium.

Question 2

(a) The economy is in equilibrium when leakages and injections are equal. In 2022 the economy
was in equilibrium, as leakages (savings plus taxation plus imports, 50 + 50 + 50 = 150) are
equal to injections (investment plus government spending plus exports, or 55 + 40 + 55 = 150).

(b) For leakages to equal injections (S + T + M = I + G + X).

In 2023, this means that 40 + 30 + 50 = 25 + G + 60.
Therefore 120 = G + 95, that is, government spending is 25.

(c) Government expenditure increases the income paid to government employees, as well as
private employees who sell goods and services to the government. In addition, governments
make welfare payments to the unemployed and aged members of society. By increasing
household incomes government expenditure increases income and employment in the
economy, and is therefore be an injection into the circular flow of income.

(d) A high level of savings means that less disposable income is being spent on consumption.
Reduced consumption will see firms reduce production and economic activity will fall. Lower
production levels will reduce incomes and could further reduce consumption.

(e) An economy will not be in equilibrium if saving, taxation, and imports (leakages) are greater
than investment, government spending and exports (injections). Savings reduce consumption,
which causes businesses to scale back production and reduce investment. Taxation that is not
used for government expenditure also reduces production. Imports take money out of the
economy, reducing the circular flow of income. However, as production falls, incomes also
decrease. This reduces consumer saving and government tax revenue, correcting the
imbalance. This adjustment in the circular flow process will continue until leakages equal
injections and the economy is back at a lower level of equilibrium income.

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 The Market Economy Eighth Edition Workbook  Chapter 2: How Economies Operate

Question 3

(a) The business cycle refers to fluctuations in the level of economic growth due to either domestic
or international factors.

(b) The business cycle has a direct relationship with standards of living because changes in the
business cycle lead to direct impacts on standards of living. For example, economies
experiencing a boom in the business cycle have greater production of goods and services, as
well as higher wages paid to households. Thus households can purchase a higher quantity due
to higher disposable incomes and experience a higher quality of life.

(c) The government can intervene in an economy to achieve equitable resource distribution that
markets would not otherwise provide. The government can focus its taxation and expenditure
on specific sectors or groups in the economy. One example is by imposing a higher rate of tax
on high income earners. The government can redistribute this taxation revenue to low income
earners (who receive a less equitable share of wages) through social welfare payments.

(d) An economic recession is the stage of the business cycle where there is decreasing economic
activity, defined as two consecutive quarters (six months) of negative economic growth, that
is, a fall in GDP. A recession, also known as an economic downturn, is generally associated
with lower demand for goods and services which results in falling production and consumption
of goods and services as well as lower levels of investment. As a result, employment falls and
many people can become unemployed. Households may be forced to rely on social security
payments and any savings they have to meet expenses while their normal sources of income
have dried up. Living standards may fall and individuals may experience other personal
problems such as deterioration in their health. Further, the government is also affected by a
recession, as it will receive less tax revenue as incomes have fallen, whilst having to increase
its expenditure on social welfare payments.

Skills Revision Activity 1

What is the effect of the activity on Does economic activity

Activity / Scenario
total leakages or total injections. expand or contract?
The Australian dollar appreciates
Total injections decrease Contracts
causing export volumes to fall.
The government increases income
taxes to help offset a budget Total leakages increase Contracts
deficit
The RBA cuts interest rates to
Total injections increase Expands
encourage businesses to invest
As a result of the closure
of Australia’s motor vehicle
Total leakages increase Contracts
production industry, import
volumes rise
Tax reforms result in a fall in tax
Total leakages decrease Expands
revenue
The government introduces a
$10bn health and education Total injections increase Expands
improvement package

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 The Market Economy Eighth Edition Workbook  Chapter 2: How Economies Operate

Skills Revision Activity 2

Individuals Income rewards Businesses

Expenditure on goods and services

Savings Financial Insitutions Investment

Taxation Governments Expenditure

Imports International Flows Exports

Leakages Injections

1 Leakages: no change initially

Injections: will fall
Economic activity: will fall
2 Leakages: no change initially
Injections: will increase
Economic activity: will increase
3 Leakages: will increase
Injections: no change initially
Economic activity: will fall initially

Year Output Income Consumption Saving

1 500 500 300 200
2 800 800 550 250
3 900 900 800 100
4 600 600 480 120
5 500 500 320 180

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