Overview

Ô Introduction
Ô The two sector model
Ô The three sector model
Ô The four sector model
Introduction
Ô In economics, the term circular flow of income or circular
flow of economic activity refers to a simple economic
model which describes the circulation/flow of income
between producers and consumers

Ô In the circular flow model, producer and consumer are

referred to as "firms" and "households" respectively
rasic terms
In the present mixed economic system we find three basic
economic units.

Ô x
 
Ô 

Ô

Ô  

xouseholds:
It is a person or a group of people that share their income.
The members of households have two functions:
Ôthey supply different factors of production
Ômembers of household also work as consumers
Úirms:
An organization that produces goods and services for sale.
Regarded as the economic units whose main objective is to
maximize profit in the production process. The three main
functions are as follows:
‡ Produce goods and services and supply them in the
market.
‡ Úirms purchase inputs or raw materials from households to
use them in the production process.

Government:
Just like households and firms the government also earns
incomes and makes expenses. Two major functions played
are:
‡ Government earns revenue either from tax or non-tax
sources both from households and firms.
Ô Government provides essential public services such as
maintenance of law and order, defense services,
judiciary etc

Úoreign Market:
It consists of two kinds of international economic
transactions i.e. export and import of goods and services
and inflow and outflow of capital.

Úinancial Institution :
Ô consists of banks and non-bank intermediaries who
engage in the borrowing (savings from households)
and lending of money.
Ô the leakage that financial institutions provide in the
economy is the option for households to save their
money.
Two Sector Model
Assumptions

xouseholds:
Ô To own all the factors of production
Ô To consume all final goods and services
Ô Their income consists of wages, rent, interest and profits

rusiness firms:
Ô To hire factors of production from households
Ô Produce and sell goods and services goods to the
households
Ô No corporate saving
Úactor Markets:
Úlow of factors like land, labor, capital and organization is
observed from households to firms and in return they
receive factor income like rent, wages, interest and profits
from firms.
Product Markets:
These transactions show money flow from households to
firm. xouseholds purchase consumer goods and services
from firms and in exchange they make payments to firms.
Two Sector Model
ÚACTOR PAYMENTS = xOUSExOLD INCOMES and
xOUSExOLD EXPENDITURE= TOTAL RECEIPTS OÚ TxE ÚIRM
So xOUSExOLD INCOMES = ÚACTOR PAYMENTS =
MONEY VALUE OÚ OUTPUT

Effects of Withdrawal and Injections

Ô Withdrawals : an amount set aside by the households

and/or by the firms, not to be spent on the goods and
services over a period of time. It is not a saving rather it
reduces the volume of the circular flow.

Ô Injections : the amount that is spent by the households

and/or firms in addition to their current incomes
generated within the regular economy. It increase the
size of the flow
Three Sector Model
Three Sector Model
 Introduction
Ô Three sector model is created by adding the
Government sector to the Two sector model

Ô Three kinds of monetary flows between the government

and the rest of the economy i.e.
1)direct taxes on both households and firms
2)government expenditure
3)transfer payments and subsidies

Ô Government spends a part of its tax revenue as ¶factor

payments· to the households and a part in the form of
transfer payments as pension and food subsidy etc
Úour Sector Model
 Úour sector model
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Introduction
Ô This circular flow of model shows the four macroeconomic
sectors of the economy i.e.
household, business firm, government, and foreign.
Ô These four sectors capture four fundamental
macroeconomic functions and their expenditures are
combined together to purchase the economy's total
production.

Assumptions:
Ô To introduce the financial market first and assumes
household saves in the financial market.
Ô There are no inter-households borrowing.
Ô If the households save a part of their income in the
financial market (such as banks, insurance companies,
stock market etc), this reduces the expenditure of
xousehold on goods and services
Ô Ultimately reduces the flow of money/income of the
economy. So saving known as the  of the
economy
Ô Again the business firms borrow from the financial markets
for investment in the capital goods (such as machineries,
factories, tools, instruments etc)
Ô This ultimately increases the productive capacity of the
business firm. So investments are known as the   for
the economy
Ô Through this investment expenditure the saving of the
households deposited in the financial market are again
bought into the expenditure stream and circular flow of
economic activity continued
Government Sector:

Ô Government purchases goods and services just as

households and firms do.

Ô It also borrows from the financial market.

Ô Also collects money from firm and household through

taxes.

Ô This money of the Government again spends in the

economy in the form of expenditure on the capital goods
and infrastructure (such as highways, power,
communication etc).
Úoreign Market(export and import):

Ô Goods and services produced within the domestic

territory which are sold to the foreigners are called
exports.

Ô On the other hand, purchases of foreign made goods

and services by domestic households are called as
imports.

Ô xere we assume that only business forms can interact

with the foreign countries and dealt with the export and
import of the country. Money goes through import from
the economy again returned back to the country
through export activities
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