Circular Flow Of Income And Expenditure In Two Three Four Sector Model

Circular Flow Of Income And Expenditure: It a model which explains the flow of income and expenditure in the circular flow model illustrates the different sectors in an economy which reveals the different sources of their incomes and the different expenditures which they have to bear.

This model is used in calculating national income, by totaling the income of all the different sectors in economy.

It is named a circular flow of Income and expenditure model because money moves in a circular motion in an economy i:e one sector spend money on another sector and receives money from same sector in an different form.

In order to understand the biggest and real world model which is called as four sector model; explanation starts from smaller and easier models. Classification of circular flow of income and expenditure different models are;

1.    Two sector economy;
·         Closed and simple economy
·         Includes household and business sectors
2.    Three sector economy;
·         Open and mixed economy
·         Includes household, business, government and capital market
3.    Four sector economy;
·         Open and mixed economy
·   Includes household, business government, capital market and foreign sectors


Explanation of different models in Circular flow of income and expenditure in each sector:

Circular Flow Of Income And Expenditure In Two Sector Model

Circular flow of income and expenditure in a two sector economy is said as a closed and simple economy. Because flow of money is takes place between only two sectors; household sector and business sector. There is no intervention of government in this form of economy and there is no interactions with outside economy i:e foreign sector. 

 

Circular flow of income in two sector economy is a closed economy, it has no foreign sector. 

Circular Flow Model in Two Sector Model

The circular flow of income and expenditure in the two sector economy is illustrated in the above figure. 

Household Sector

Household’s different sources of income and expenditure in circular flow of income and expenditure in two sector economy:

  1. They are the only buyer of goods and services produced by the firms
  2. They supply the factors of production, i:e land, labour, capital and organization.  
  3. Their entire income is spent on goods and services bought from business sector. 
  4. Therefore, they do not make any savings and investments.
  5. They generate income from the factors of production they provided in form of rent, wages, interest and capital.

Business Sector

Business sectors in two sector economy:

  1. The business sector is the producer in an economy, who provides goods and services to household. For this they receive money from household sector.
  2. For producing goods and services household sector provides the factors of production, land, labour, capital and entrepreneur.  
  3. Pays household sector in form of rent, wages, interest, capital. 

Equilibrium in the two-sector economy

Equilibrium in the circular flow of income and expenditure in a two-sector when they attain the situation where all two sectors are equal:

i:e. Income (Y) = Consumption (C) =
output(O)

Circular flow of income in two sector economy- Assumptions  

Circular flow of income and expenditure in two sector economies is not a real economic model. Assumptions in the circular flow of income and expenditure in two sector economy are:

  1. There are only two sectors in this model;

·         Household

·         Business

  1. No government involvement in economic activities.
  2. Since, there is no foreign sector in this model so there is no import or export activities.

Because of these reason circular flow of income in two sector economy is a closed economy.

Circular Flow Of Income And Expenditure In Three-Sector Economy 

Circular flow of income and expenditure in a three-sector economy includes three sectors-household sector, business and government sector. 

Circular flow of income in three sector economy is not a closed economy but they have no international trade relations. 

Circular flow model in three sectors economy explain:

Circular Flow Of Income In Three Sector Economy

Household Sector

Household in circular flow of income and expenditure in three sector economy:

  1. People from household sector provides factor of production which are; land, labour, capital and organization. 
  2. For which they earn their income in form of rent, wages, interest, capital.
  3. Government sector also purchases services from the household sector.
  4. Household spend their income by purchasing goods and services from business sector.
  5. Pay direct and indirect taxes to government which creates leakages.
  6. Their entire income is spent on goods and services and taxes. 
  7. Therefore, there is no existence of financial market in the economy i:e there is no savings and investments in economy..

Business Sector

Firm’s different sources of income and expenditure in circular flow of income and expenditure in three sector economy:

  1. The business sector is the producer in an economy, who provides goods and services to household. For this they receive money from household sector.
  2. For producing goods and services household sector provides the factors of production, land, labour, capital and entrepreneur.  
  3. Pays household sector in form of rent, wages, interest, capital. 
  4. They sell their goods to the household and government and receives payments in return.
  5. They pay taxes to the government.
  6. Government sector provides subsidies and other benefits to the firms.

Government Sector

Government sector income and expenditure in circular flow of income and expenditure in three sector economy:

  1. Household sector pays direct tax which is also called income tax.
  2. In return they provides be various benefits to the household sector like subsides, welfare etc.
  3. Firms have to pay taxes for production and profit.
  4. And, in return firms receives the transfer payments, like- subsidies.
  5. Also they buy goods and services from firms/ business sector.

Financial Market In Circular Flow Of Income In Three Sector Economy

Circular Flow Of Income In Three Sector Economy- With Financial Market

Financial Sector income and expenditure in circular flow of income and expenditure in three sector economy:

 

  1. Capital market receives money from different sectors which is an access portion of their earnings called savings.
  2. Capital market lends money to firms and government to increase their resources.
  3. In case of financial debt they provides borrowings to the government sector.
  4. These borrowing take place as sale of government bonds and other securities to the public or to financial intermediaries.  
  5. Increase in government borrowings results in increases to the domestic debt.  
  6. And, when the public sector have a budget in surplus, governments pay off old borrowings, and the rate of pay off is faster than the rate of new borrowing occurs.
Aggregate demand in the circular flow of income in three sector economy is calculated by adding consumption spending (C), investment spending (I) and government spending (G):
Y = C + I + G
Where Y is Income,
           C is Consumption,
              I is Investment, and
              G is Government Spending

Circular Flow of Income In Four Sector Model

The circular flow model in the four sector economy is an real model which explains the flow of income and expenditure in real world.

We will study four different sectors in this model; household, firms, government, foreign. Also, there are introduction of leakages and injections in this sector.

Each sector has the dual function in circular flow of income and expenditure, as each sector has to make payments to some sectors and to receive payments from some sectors.

 

Circular Flow Of Income In Four Sector Economy

Circular Flow Of Income In Four Sector Economy

Household Sector

  1. They are the buyers of goods and services produced by the firms.
  2. They supply the factors of production, i:e land, labour, capital and organization and receives payments for their supply.
  3. Household sector pays direct and indirect taxes to government and firms respectively.
  4. The also purchases the services from the household and in return they make transfer payments to the household sector.
  5. Household Sector exports one of the factors of production i:e, manpower to the foreign sector.
  6. And their is an existence of imports.

Business Sector

  1. The business sector is the producer in an economy, who provides goods and services to household. For this they receive money from household sector.
  2. For producing goods and services household sector provides the factors of production, land, labour, capital and entrepreneur.  
  3. Pays household sector in form of rent, wages, interest, capital. 
  4. They pay taxes to the government and also it is one of the factor of leakage from the circular flow.
  5. Government will purchase goods and provide subsidies and other benefits to firms.
  6. Business sector borrow funds from the financial market.
  7. Firms import raw materials from the foreign sector (rest of the world) and business sectors make payment for that.
  8. Also, firms export their final goods and services to the foreign sector and receive payment for that.

Government Sector

  1. Household sector pays the income tax and indirect tax imposed on goods and services
  2. In return, they provide different benefits or transfer payments to them.
  3. Firms pay taxes to the government, for production and the profits.
  4. They provides subsidies and purchase goods and services from firms.
  5. Capital market lends money to government sector in case of financial deficit
  6. Also, the government uses financial market for making their savings and investment.

Foreign Sector

  1. Business sector make payment to foreign sector in return for the goods and services imported.
  2. They make payments for the imports which they received from the foreign sector.
  3. Household Sector exports one of the factors of production i:e, manpower to the foreign sector and foreign sector makes the payment for the same.
  4. Plus, there are net transfer payments which are made by the foreign sector to households.

Capital Market

 

  • Capital Market receives income from different sectors as they deposit their savings.
  • Capital market lends money to the firms or government sector for increasing their resources.
The model can be described using the
equation
National Income (Y) = consumption
expenditure (C) + Investment (I) + government expenditure (G)
 Including Taxes we get;
National Income (Y) = consumption
expenditure (C) + Savings (S) + Taxation (T)
Equating the two equations, we get
Consumption expenditure (C) +
Investment (I) + Government (G) = Consumption Expenditure (C) + Savings (S) +
Taxation (T)
This results to: I + G = S + T
Investments are of two types domestic investment (ID) and foreign investment
(IF) and get
ID + IF + G = S + T
If IF = Exports (X) - Imports (M)
ID + (X-M) + G= S + T
ID + (X-M) + G= S + (T-G)
This is the equilibrium state of
circular flow of income and expenditure.

 

 

 

 

 

 

 

 

 

 

 

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