In a two-sector economy, households provide factors of production to firms and receive income. If households save part of this income, what is affected ?
Show answer & explanation
Correct answer: A
Explanation
Answer: The circular flow becomes a leakage
Explanation: In a two-sector economy (households and firms), income flows continuously between the two in the form of wages, rent, interest, and profits. When households save a part of their income instead of spending it, that portion does not return to firms as consumption expenditure. This reduces the overall flow of money in the economy. Hence, savings act as a leakage from the circular flow of income.
Additional Key Points:
A two-sector economy includes only households and firms, with no government or foreign sector.
Leakages refer to withdrawals from the circular flow (e.g., savings).
Injections are additions to the flow (e.g., investment).
For equilibrium, Savings (S) = Investment (I).
If savings increase without a corresponding increase in investment, total income and output may fall.
Potential Exam-Oriented Questions & Answers:
Question: What are injections in a two-sector economy?
Answer: Investment by firms
Question: What happens if savings exceed investment?
Answer: National income and output may decrease