Consider the hypothetical example of Dominion Island that has firms producing only two goods, gold and cotton, the proceeds of which it uses to purchase other goods and services from neighbouring islands through its banks. Assuming
that all other required institutions in an economy are prevalent in this island, discuss the circular flow of income and
spending in Dominion Island. No diagram is required.

Circular Flow of Income simply refers to how money moves from one point to another through an economy.

Explanation:

Inflow

In every economy, the household sector must engage in spending. This is referred to as Consumption (C).    

When injects money via public projects, and other forms of spending, it is referred to as Government Spending (G).

In the case above, the money flows from those who produce the gold and the cotton.

The two firms producing goods (gold and cotton) also inject money into the economy when they invest and expand their operations. This is referred to as (I).    

As the produce gold and cotton and export to other neighbouring Islands, more money flows into the economy. This is typified by (X).

From the monies they receive, they pay their workers the banks make money from the transactions and also pay their workers, hence the Consumption loop is completed.  

Outflow

Both the bank and the companies producing gold and cotton and the workers who have received payment all pay taxes (T) to the government. This reduces the flow of money in circulation but also enables Government Spending. Hence the Government Spending loop is completed.

The household and businesses also keep monies aside. This is called savings (S) and also has a way of reducing money from the economy when it increases.

Another leakage happens when the two firms import raw materials and labour for their production. Let's call this (M). When importation happens, money leaves the economy and the Import-Export loop is completed.

Let's examine the Inflow-Outflow factors      

All the income (inflow) into Dominion Island are captured as C + G + X + I while  

all the expenditure/outflows of Dominion Island are captured as T + S + M.

The relationship between the inflow and the outflow also helps us to understand the Gross Domestic Product of Dominion Island.

"GDP of Dominion Island is defined as the  value (in monetary terms) of all finished goods and services made within it in a given period." It can also be summarised as "the sum of monies spent by consumers, the government, monies invested by the firms in Dominion Island, and the income from exports minus the total value of imports into Dominion Island.

Put in the form of an equation GDP for Dominion Island therefore  

= C + G + I + (X – M).

Cheers!

Explanation:

The groups in this island of Dominion are;

1.  the firm

2. the banks

3. the workers

4. neigboring islands

For the firms, they have:

1. In one case cash outflows to labourers who work to produce the two products gold and cotton.

2. And in another case, the firms are consumers since they pay for other products available in neighbouring islands.

For the banks, they get cash inflows since they receive payments from the two firms.

For workers, who receive their wages from the firms take this wages to their individual households as cash inflows which they spend in the economy making them Consumers and they may likely save some part of their wages.

For the neighbouring islands, they receive cash inflows from Dominion island as exports.

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