Explain the effect of financial crisis taken place in the west using circular flows of income?

Answer 1

The balance of the circular flow of income is disrupted by the crisis.

In short, withdrawals have increased and injections have decreased.

1) Because of the huge national and international debt within our economy, the government raises taxation and decreases government expenditure. The households have lower income and the firms aren't being funded anymore by the government. Thus people have less money to spend and firms aren't able to expand.

2) Because of the instability of the economy and the dip in confidence, households tend to save their money instead of spend it. Additionally, financial institutions only invest when they expect the value to rise - which is not the case today and so investment goes down.

3) Because of the fall in expenditure and investment, the firms have to cut their cost and they do so by decreasing wages and firing their workers. The households have therefore less money to spend and so they consume less products which results into the firms having lower profit.

In a crisis, the circular flow of income becomes a vicious circle. The fall in injections decreases aggregate demand which leads to the fall in aggregate supply. The economy thus shrinks.