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Circular Flow in 2, 3, 4 sector

11 Feb 201912 May 2024
The concept of circular income flow illustrates the continuous movement
consumers (households). In this model, households provide factors of production,
receive incomes in the form of wages, rent, interest, and profits. Businesses
sell to households, generating revenue. This revenue is used to pay incomes
highlights the interdependence between the different sectors of the economy
the market, influencing economic activity and stability.

Circular Income Flow in a Two Sector Economy

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Two-sector economy is a simplified theoretical framework used to analyze

and businesses. In this model, households provide labor and other resources
Households consume these goods and services using the income earned
and consumption, with no government or foreign trade interventions. The
an economic system by focusing on the flow of goods and services and
other complexities.

Features of Two Sector Economy:

Circular Flow of Income:

The economy operates on the basic principle of the circular flow of income,
return, receive wages and salaries. Businesses sell goods and services back

No Government Intervention:

The model assumes there is no government sector. Therefore, there are

economy.

No External Sector:

This model does not consider foreign trade; there are no imports or exports.

Simplified Financial Flows:

Financial markets and various forms of financial intermediaries are typically
exchanges between producers and consumers.

Consumption and Savings:

The only economic activities considered are consumption by the households

and businesses invest all they recoup from selling goods and services.

Labor as Primary Factor of Production:

The model often assumes labor is the primary, if not the only, factor of production
resources are generally not emphasized.

Closed Economy:

As a closed economy with no external influences, economic performance

investment.

Market Equilibrium Focus:

The two-sector model focuses heavily on how market equilibrium is achieved

between consumer spending and business production.

Real flows of resources, goods and services have been shown in Fig. 6.1. In the upper
ability flow from households to business firms as indicated by the arrow mark.

In opposite direction to this, money flows from business firms to the households as

In the lower part of the figure, money flows from households to firms as consumption
the firms, while the flow of goods and services is in opposite direction from business
Thus we see that money flows from business firms to households as factor payments
flow of money or income. This circular flow of money will continue indefinitely week
be pointed out that this flow of money income will not always remain the same in volume.

In order to make our analysis simple and to explain the central issues involved,
households save from their incomes, nor the firms save from their profits. We further

In other words, the government does not receive any money from the people by
services produced by the firms or on the resources and services supplied by the
services, nor exports anything. In other words, in our above analysis we have not
flow of money that occurs in the functioning of a closed economy with no savings and

Circular Income Flow in a Three Sector Economy with Government

Three-sector economy is an expanded model of the basic economic system

model, households provide labor and receive income from businesses, which
flow of income by collecting taxes and redistributing income through public
government activity influences economic activity by affecting consumption,
of the government sector allows for a more realistic analysis of economic
shaping economic growth, employment, and overall market stability.

Features of Three Sector Economy:

Government Intervention:

The inclusion of the government sector allows for the consideration of government
which significantly impact economic activities.

Taxation and Redistribution:

Government collects taxes from households and businesses, which can

development, and other purposes. Taxation affects disposable income and

Public Goods and Services:

Government provides public goods and services, such as education,

functioning of the economy and society.

Regulatory Framework:

Government enforces regulations and laws that govern various economic

protection, and consumer rights.
 Fiscal Policy Tools:

Governments can use fiscal policy tools, such as changes in taxation and
address socio-economic issues like unemployment and inflation.

Budgetary Constraints:

Government expenditure and revenue influence fiscal deficits or surpluses,

economic stability.

Government Borrowing and Debt:

Governments may borrow funds by issuing bonds or treasury securities

levels and servicing costs affect interest rates and future fiscal flexibility.

Externalities and Market Failures:

Government intervenes to address market failures, externalities, and public

distribution of benefits across society.

In our above analysis of money flow, we have ignored the existence of government
because government absorbs a good part of the incomes earned by households. Government

Here we will concentrate on its taxing, spending and borrowing roles. Government
expenditure takes many forms including spending on capital goods and infrastructure
public health and so on. These add to the money flows which are shown in Fig.
government purchases of goods and services from firms and households are shown

Government expenditure may be financed through taxes, out of assets or by borrowing.

labelled as tax payments in Fig. 6.3 This money flow includes all the tax payments
Transfer payments are treated as negative tax payments.

Another method of financing Government expenditure is borrowing from the financial

to the Government and is labelled as Government borrowing (To avoid confusion
Government borrowing increases the demand for credit which causes rate of interest
It follows from above that the inclusion of the Government sector significantly affects
the sum of consumption expendi-ture (denoted by C), investment expenditure (I) and

Total expenditure (E) = C + I + G …..(i)

Total income (K) received is allocated to consumption (C), savings (S) and taxes (T).

Y = C + S + T … (ii)

Since expenditure) made must be equal to the income received (Y), from equations

C + I + G = C + S + T … (iii)

Since C occurs on both sides of the equation (iii) and will therefore be cancelled out,

I + G = S + T …(iv)

By rearranging we obtain

G – T = S – I … (v)

Equation (v) is very significant as it depicts what would be the consequences if

greater than the tax revenue (7), that is, G >T, the government will have a deficit
financial market.

For this purpose, then private investment by business firms must be less than
investment in the economy. In other words, Government borrowing crowds out private

Money Income Flows in the Four Sector Open Economy:

Four-sector open economy model expands upon the traditional economic

foreign sector. In this model, households provide labor and receive income,
collects taxes and redistributes them through public spending. The addition
exports, imports, and capital flows. This open economy allows for the exchange
significantly influencing domestic economic activities. It highlights the interdependence
trade and investment can impact economic growth, balance of payments,
view of an economy’s interaction within a global context.

Features of Four Sector Open Economy:

International Trade:
This economy engages in exporting and importing goods and services,
wider range of products and markets.

Capital Flows:

Investments can flow in and out of the country, including foreign direct
financial stability and growth prospects.

Exchange Rate Mechanisms:

The value of the nation’s currency against others plays a crucial role, affecting

Economic Policies:

The government in a four-sector economy has additional policy tools, such

economic outcomes and manage international relations.

Balance of Payments:

Transactions with the rest of the world are recorded in the balance of
account, reflecting the economic transactions between residents and non

Global Supply Chains:

Businesses can partake in global supply chains, optimizing production processes

to maximize efficiency and cost-effectiveness.

Risk Diversification:

Economic and financial risks can be diversified away from domestic markets
reducing volatility.

Economic Interdependence:

The economy is affected by global economic conditions, including international

trends, which can have significant impacts on domestic growth and stability.

We now turn to explain the money flows that are generated in an open economy,
inclusion of the foreign sector will reveal to us the interaction of the domestic economy
households through exports and imports of goods and services as well as through
produced within the domestic territory which are sold to the foreigners are called exports.
On the other hand, purchases of foreign-made goods and services by domestic households
occur in the open economy when exports and imports also exist in the economy. In
that interact with foreign countries and therefore export and import goods and services.

A flow of money spending on imports have been shown to be occurring from the
contrary, flow of money expenditure on exports of a domestic economy has been
domestic economy.

If exports are equal to the imports, then there exists a balance of trade. Generally,
value of imports, trade surplus occurs. On the other hand if value of imports exceeds

In the open economy there is interaction between countries not only through exports
funds or what is also called financial market. These days financial markets around

When there is a trade surplus in the economy, that is, when exports (X) exceed
foreigners will borrow from domestic savers to finance their purchases of domestic
foreigners, that is, acquire foreign financial assets.

From the circular flows that occur in the open economy the national income must
where X represents exports and M represents imports. Imports must be subtracted
value of net exports. Thus, in the open economy

National Income = C + I + G + NX

where NX represents net exports, X-M.

Since national income can be either consumed, saved or paid as taxes to the Government

C + I + G + NX = C + S + T

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movement of income within an economy between producers (businesses) and
production, such as labor, land, and capital, to businesses. In return, they
Businesses use these factors to produce goods and services, which they then
incomes to the households, completing the cycle. The circular flow model
economy and is fundamental in understanding how income circulates within

analyze economic activities, consisting of only two main sectors: households

resources to businesses, which in turn produce goods and services.
earned from businesses. This interaction forms a closed loop of production
The two-sector model helps economists understand the basic functions of
the income generated between businesses and households, excluding

income, where households provide labor and resources to businesses, and in

back to households, completing the cycle.

are no taxes, government spending, or public policy influences on the

exports. All economic activity is confined within the national borders.

 typically excluded from this model. All transactions are straightforward

households and investment by businesses. Households spend all they earn,

production provided by households. Other factors like capital and natural

erformance in this model is driven solely by domestic consumption and business

achieved in the goods and services market, examining the dynamics

upper loop of this figure, the resources such as land, capital and entrepreneurial

as factor payments such as wages, rent, interest and profits.

consumption expenditure made by the households on the goods and services produced by
business firms to households.
 payments and then it flows from households to firms. Thus there is, in fact, a circular
week by week and year by year. This is how the economy functions. It may, however,
volume.

involved, we take many assumptions. In the first place, we assume that neither the
further assume that the government does not play any part in the national economy.

by way of taxes, nor does the government spend any money on the goods and
the households. Thirdly, we assume that the economy neither imports goods and
taken into account the role of foreign trade. In fact we have explained above the
and no role of government.

system that includes households, businesses, and the government. In this

which produce goods and services. The government enters the circular
public spending, such as infrastructure, education, and social services. This
nsumption, investment, and savings decisions within the economy. The inclusion
economic dynamics, acknowledging the role of public policies and services in

government policies, including taxation, public spending, and regulations,

can be used for public expenditure, social welfare programs, infrastructure

and consumption patterns.

ducation, healthcare, defense, and infrastructure, which are essential for the

economic activities, including business operations, labor markets, environmental

 and government spending, to stabilize the economy, promote growth, and

surpluses, which can impact borrowing, public debt levels, and long-term

to finance deficits or invest in development projects. Government debt

public goods provision, ensuring efficient resource allocation and equitable

government for the sake of making our circular flow model simple. This is quite unrealistic
Government affects the economy in a number of ways.

Government purchases goods and services just as households and firms do. Government
infrastructure (highways, power, communication), on defence goods, and on education and
6.3 where a box representing Government has been drawn. It will be seen that
shown as flow of money spending on goods and services.

borrowing. The money flow from households and business firms to the government is
payments made by households less transfer payments received from the Government.

financial market. This can be represented by the money flow from the financial market
confusion we have not drawn this money flow from financial market to the Government).
interest to rise.
 affects the overall economic situation. Total expenditure flow in the economy is now
and Government expenditure (denoted by G). Thus

(T). Thus

equations (i) and (ii) above we have

out, we have

if government budget is not balanced, that is, if Government expenditure (G) is

deficit budget. To finance the deficit budget, the Government will borrow from the

than the savings of the households. Thus Government borrowing reduces private
private investment.

economic framework by including households, businesses, government, and the

income, businesses produce goods and services, and the government
addition of the foreign sector introduces trade with other countries, including
exchange of goods, services, and finances across international borders,
interdependence of economies globally and underscores how international
payments, and national economic policies. This model provides a comprehensive
services, which allows it to benefit from comparative advantages and access a

investment (FDI) and portfolio investments, influencing the economy’s

affecting trade competitiveness, inflation, and external debt.

such as tariffs, trade agreements, and exchange rate policies, to influence

of payments, including the trade balance, capital account, and financial

non-residents.

processes by locating different stages of production in different countries

markets through international investments and operations, potentially

international economic crises, foreign economic policies, and global market

stability.

economy, that is, economy which have trade relations with foreign countries. Thus, the
economy with foreign countries. Foreigners interact with the domestic firms and
through borrowing and lending operations through financial market. Goods and services
exports.
 households are called imports. Figure 6.4 illustrates additional money flows that
In our analysis, we assume it is only the business firms of the domestic economy
services.

the domestic business firms to the foreign countries (i.e., rest of the world). On the
been shown to be taking place from foreign countries to the business firms of the

Generally, exports and imports are not equal to each other. If value of exports exceeds the
exceeds value of exports of a country, trade deficit occurs.

exports and imports of goods and services but also through borrowing and lending
the world have become well integrated.

exceed imports (M), net capital inflow will take place. By net capital inflow we mean
domestic exports. In this way as a result of net capital inflow domestic savers will lend to

must be measured by aggregate expenditure that includes net exports, that is, X-M
subtracted from the total expenditure on foreign produced goods and services to get the

Government we have
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