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

Introduction Of Circular Flow Model

Circular Flow Of Income And Expenditure:The amount of income generated in an economy in a period of time (national income) can be viewed from three perspectives.  These are:

  • Income,
  • Product, and
  • Expenditure.

The above assertion implies that we can view national income as either the total sum of all income received within a particular period called income. there are three methods to determine national income. However, every approach gives the same result.

To understand the circular flow of income and expenditure, it can be divided into three sectors:

  1. A simple and closed economy with no government and international transactions, i.e., two-sector economy;
  2. A mixed and open economy with savings, investment and government transactions, i.e., three-sector economy; and
  3. A mixed and open economy with government activities ,savings, investment, and foreign trade, i.e., four-sector economy.

Here is the explanation of Circular flow of income and expenditure in different sectors

Circular Flow Model in Two Sector Model

Circular flow of income and expenditure in a two sector economy includes  household sector and business sector. No intervention of government sector. As a result, there are no public expenditure, taxes, subsidies,social security contribution, etc. 

Circular flow of income in two sector economy is also called as closed economy, which has no international trade relations. 

Circular Flow Model in Two Sector Model
Circular Flow Model in Two Sector Model

The circular flow of income and expenditure in the two sector economy is depicted in the given figure. Upper part is the product market and lower part is the factor market.

Let’s discuss circular flow model of two sectors:

Household Sector

Circular flow of income and expenditure of household sector in two sector economy:

  1. The household sector is the only buyer of goods and services and the only supplier of factors of production, i.e..land, labour, capital and organisation.  
  2. Households spend their entire income on the purchase of goods and services produced by the business sector. 
  3. The household sector spends the entire income on the purchase of goods and services. Therefore, there are no savings and investments.
  4. The household sector receives income from the business sector by providing the factors of production owned by it.

Business Sector

Circular flow of income and expenditure of business sector in two sector economy:

  1. The business sector is the firms that produce goods and services.
  2. And, receive income by selling the produced goods to the household sector.
  3. The household sector buys the output of products and services from  the business sector. 
  4.  Business sector or firms pays compensation to the household sector   for providing the factor of production (rent,wages, profit,interest).

Equilibrium in the two-sector economy

Circular flow of income and expenditure in a two-sector economy can attain the equilibrium in when the economy achieves a situation in which there is no change. All two sectors are equal:

i.e. Y=E=O

Y = C

 

                        Where Y         is            Income

                                   C          is            Consumption

                                   O          is            output 

Circular flow of income in two sector economy- Assumptions  

Circular flow of income and expenditure in two sector economies is not a real life example. It is the basic model which gives helps to understand the bigger and real models more clearly and easily. So, here are the assumptions for the circular flow of income and expenditure in two sector economy:

  1. In the two sector model of income there are only two sectors; household sector and business sector.
  2. There are no government interventions over economic activities in circular flow of income in two sector economy.
  3. Business sectors do not get  involved in any import or export activities. Thus, it creates a closed economy in the circular flow of income in two sector economy.

Circular Flow Of Income In Three Sector Economy 

Circular flow of income and expenditure in a three-sector economy refers to the three sectors i:e household sector, business and government sector. No foreign sector i:e no exports and imports

Circular flow of income in two sector economy is a closed economy, and has no international trade relations. 

Circular Flow Of Income In Three Sector Economy
Circular Flow Of Income In Three Sector Economy

Let’s discuss circular flow model of three sectors:

Household Sector

Circular flow of income and expenditure of household sector in three sector economy:

  1. The household sector is the only buyer of goods and services and the only supplier of factors of production, i.e..land, labour, capital and organisation.  
  2. Households spend their entire income on the purchase of goods and services produced by the business sector. 
  3. The household sector spends the entire income on the purchase of goods and services. Therefore, there are no savings and investments.
  4. The household sector receives income from the business sector by providing the factors of production owned by it.
  5. Household sector pays direct taxes and commodity taxes in terms of building up the leakage from the circular flow.
  6. On the other hand, the government sector also purchases the services from the household sector and makes transfer payments to the household sector which has low income. 

Business Sector

Circular flow of income and expenditure of business sector in three sector economy:

  1. Firms receive economic resources from the household sector and in exchange for factors of production firms pay rent,wages, profit and interest and also offer their goods and services. 
  2. Business sector pays taxes to the government also constituting leakage from the circular flow.
  3. Government sector will purchase the final goods from the business sector as well as make transfer payments i:e, subsidies and other benefits to firms to induce production from the other sectors.

Government Sector

Circular flow of income and expenditure of government sector in four sector economy:

  1. Firstly, the flow of income and expenditure between the household sector and the government, the household sector pays income tax and commodity tax to the government. 
  2. On the other hand, the government makes transfer payments i;e various benefits to the household sector,
  3. Business firms have to pay taxes for production and for the profit which the firms make.
  4. On the other hand, the government provides subsidies, makes transfer payments, and pays for the goods and services it purchases from the business sector.

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

Financial Market

Circular flow of income and expenditure of financial sector in three sector economy:

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

 

  1. Household, business, and government sectors deposit their savings i:e access income to the capital markets. 
  2. Savings from all sectors are transferred to the business sector or government sector as borrowings for making investments in different projects.
  3. The government borrows from financial markets in case of financial deficit.These borrowing are in the form of sales of government bonds and other securities to the public or to financial intermediaries.  
  4. Repeated government borrowing increases to the domestic debt.  
  5. And,when the public sector runs in budget surplus. Governments pay off old borrowings, and the rate of pay off is faster than the rate of new borrowing occurs, which creates a net flow of funds into financial markets.

To calculate the aggregate demand in the circular flow of income in three sector economy, add 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 4 Sector Model

The circular flow model in the four sector economy provides a realistic picture of the circular flow in an economy. Four sector model studies the circular flow in an open economy which comprises the household sector, business sector, government sector, and foreign sector.

The foreign sector has an important role in the economy. When the domestic business firms export goods and services to the foreign markets, injections are made into the circular flow model. On the other hand, when the domestic households, firms or the government imports something from the foreign sector, leakage occurs in the circular flow model.

The circular flow of income in four sector economy can be explained by the flowing diagram:

From the viewpoint of the circular flow of income, each sector has dual roles to play in the economy; while a sector receives certain payments from other sectors, it pays back to those sectors as well. The circular flow of income in different sectors can be expressed as follows:

Circular Flow Of Income In Four Sector Economy
Circular Flow Of Income In Four Sector Economy

Household Sector

  1. Household sector provides the factors of the production such as land, labour and capital and enterprise that the producers require to produce goods and services.
  2. They also receive payments as in rent, wages, interest and profits from the business sector.
  3. Household sector pays direct taxes and commodity taxes in terms of building up the leakage from the circular flow.
  4. On the other hand, the government sector also purchases the services from the household sector and makes transfer payments to the household sector which has low income.
  5. All the expenditure is said to be injected into the circular flow.
  6. Household Sector exports one of the factors of production i.e, manpower to the foreign sector.
  7. Purchases of foreign-made goods and services by domestic households are called imports.

Business Sector

  1. Firms act as a part in receiving economic resources from the household sector and in exchange for consumer expenditure, they also provide household sectors goods and services.
  2. The action of the business sector pays taxes to the government also constituting leakage from the circular flow.
  3. Government sector will purchase the final goods from the business sector as well as make transfer payments i:e, subsidies and other benefits to firms to induce production from the other sectors.
  4. Business sector gets their resources from borrowing funds from the financial market.
  5. Firms import raw materials from the forign sector(rest of the world) and business sectors make payment for that.
  6. Also, firms export their final goods and services to the forign sector and receive payment for that.

Government Sector

  1. Firstly, the flow of income and expenditure between the household sector and the government, the household sector pays income tax and commodity tax to the government.
  2. On the other hand, the government also makes transfer payments to the household sector in the form of various benefits and services like pension funds, relief, sickness benefits, health, education, and other services.
  3. Business firms pay different types of taxes to the government, for production and the profit which the firms make.
  4. On the other hand, the government provides subsidies, makes transfer payments, and pays for the goods and services it purchases from the business sector.
  5. In case of financial deficit the government sector borrows money from financial markets against government bonds and securities.
  6. Also, the government makes their savings and investment in the financial market.

Foreign Sector

  1. The foreign sector receives income from the business sector in return for the goods and services imported by the latter.
  2. Foreign sectors need to make payment to the business sector from where imports have been made.
  3. Household Sector exports one of the factors of production i.e, manpower to the foreign sector and forign sector makes the payment for the same.
  4. Plus, there are net transfer payments which are made by the forign sector to households.
  5. Purchases of foreign-made goods and services by domestic households are called imports.

Capital Market

  1. Household, business, and government sectors deposit their excess of income to the capital markets as savings.

These savings are borrowed by the business sector or government sector for making investments in different projects.

The model can be described using the equation

Y= C + I + G

Where Y= produced goods and services; C= consumption expenditure; G= government expenditure.

Introducing taxation in the model to equate the government expenditure, we get

Y= C + S + T

Where, S= Saving; T= Taxation

Equating the two equations, we get

C + I + G = C + S + T

This results to: I + G = S + T

Introducing foreign sector, we segregate investment into domestic investment (ID) and foreign investment (IF) and get

ID + IF + G = S + T

If IF = X-M

Where X= Exports; M= Imports;

ID + (X-M) + G= S + T

ID + (X-M) + G= S + (T-G)

This equation shows equilibrium in the circular flow of income and expenditure.

Economy Leakages and Injections

"Leakages and Injections

Leakages

When households engage in savings and purchase of goods and services from abroad, we experience temporary withdrawal of funds from circulation.  Therefore, leakages in the circular flow are savings, taxes and imports

Injection

While, economy receive additional income from exports and foreign sector investment in domestic market. These are reasons for injection into the circular flow of income and expenditure.

Total Leakages            =            Total Injections

C + I + G + (X-M) = C + S + Net Taxes

S + Net Taxes + Imports = I + G + Exports

S = I + (G – NT) + (X – M)  

Think about the circular flow of income as you imagine a water tank. 

Tank is injected by the investment, government spending and spending by foreigners and its leak out from savings, taxes and spending on imports. To attain the level of equilibrium leak-outs are equal to injections, which keep the tank stable.

 

leakages and injections
leakages and injections
  1. If injections get greater than withdrawals or leakages then the level in the tank will rise. 
  2. If withdrawals are greater than injections then the level in the tank falls.
  3. To make injection equal to leakages, we need to make planned I+G is equal to planned S+T, and total spending is equal to total income and total demand is equal to total supply.  Then we have a ‘stable economy’.
  4.  If leakages are higher than injections i.e., planned savings plus taxes are greater than planned investment plus government spending (S+T > I+G), economy contracts resulting in inventory accumulation, too little spending and drop in prices.  
  5. If injections are higher than leakages, i.e., planned investment plus government spending are greater than planned saving plus taxes (I+G > S+T), the economy expands resulting in more goods and services produced, and higher prices.

 

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