● Circular Flow of Income is defined as the flow of payments and receipts for goods and

services and factor services between different sectors of the economy. Circular Flow can be
viewed from two angles: real and money flow.

● Real Flows: Real flows consist of the flow of factor services and goods and services among
different sectors of an economy.

● Money Flows: Money flows consist of the flow of money incomes for factor services such as
money wages, rent, interest, etc. and money expenditure incurred on the purchase of goods
and services.

● Note: Real flow determines the magnitude of economic growth, the more the factor services
offered to the firms, the more is the volume of production and it, therefore, speeds up the
process of economic growth.

● The economy is divided into four sectors:

● i) Household Sector

● ii) Business Sector or Firms

● iii) Government Sector

iv) Rest of the world

● In the two-sector model of national income accounting there exists only households and
firms.

● The assumptions of this model are as follows;

 Only two sectors – Households and firms.

 There exists no government intervention over economic activities.

 The business sector does not carry out economic activities, thus creating a closed economy.

● We can represent the two-sector model as follows beside;

● Real flow indicates the flow of factor services from households to businesses and the flow of
goods and services from the business sector to the households.

● Monetary flow, on the other hand, indicates the flow in terms of money, factor rent, wage,
interest, and profit from the business to the household sector, and the consumption
expenditure made by household flow to the business sector as revenue for the firms. Thus,
in our two-sector simple economy with neither government nor foreign trade, investment is
identically equal to saving.

● Therefore, in this model we can reach the following equation,

● Monetary receipts of producers = Income of households = Consumption expenditure by

● Households do not spend their entire income on consumption. A part of the income which is
not spent by the households on consumer goods is called savings.
 ● Savings by the households reduces the consumption expenditure and the level of circular
flow of income. Thus, savings represents a type of leakage.

● Investment expenditure on the other hand, creates income for the firms that produce
capital goods and for the factors used in the production process. Investment increases the
level of income so it’s an injection.

In this model, a new sector referred to as the capital market is introduced. A part of the income of
households flows to the firms in the form of consumption expenditure and a part of the income
flows to the capital market in the form of savings.

In this model of circular flow, if the investment expenditure by the firms is equal to the savings of
the household sector, then there will be equilibrium.

Therefore, the equilibrium condition;

Savings = investment

• If S>I – The flow of income declines this is because the leakages are more than the
injections.

• If I>S – The flow of income increases this is because injections are more than leakages.

THREE – SECTOR MODEL

● In this model, there exist the government sector, the household and the firm.

● The three major activities of the government in this sector include:

i) Taxation

ii) Government spending on commodities and factor services

iii) Transfer Payments

● The expenditures which are incurred by the government on various social security and
welfare schemes are known as transfer payments. Example: Pensions and scholarships.

● Taxes constitute the leakages from the flow of income, as they reduce the income of the
individual.

● Government expenditure (G), on the other hand, is injection into the flow of income as it
adds to aggregate demand in the form of government purchases of factor services.

● If the government somehow manages to spend all its leakages from the circular flow or the
income received in the form of taxes, it flows back to the households and business sector in
the form of subsidies and other government expenditures. This leads to continuous circular
flow of national income within the economy of the any country.

● In this model, the equilibrium condition is as follows;

● Savings + Taxes = Investment + Government Expenditure

 When ( S + T ) > ( I + G ) – This means that the leakage of income from the circular flow is
greater than the injection into the circular flow.
 When ( I + G ) > ( S + T ) – This means that the injection into the circular flow is greater than
the leakage from it.

FOUR-SECTOR MODEL

• The four sector model analyses the circular flow in an open economy comprising the
household sector, business sector, government sector and the foreign sector.

• The happenings in each of the four sectors can be considered as follows;

• Household sector;

• Receipts – Factor income is received in the form of rent, wages, interest, and profit from the
business sector. It also receives transfer payments from the government sector in the form
of age-old pensions and various welfare schemes.

• Payments – Income flows into the government sector, business sector and the capital
markets in the form of consumption expenditure, taxes, and savings.

Business sector;
Receipts – Income from the sale of goods and services, income from exports, subsidies from
the government sector and borrowings from the capital markets.
Payments – Principle payments are factor payments, import payments and savings from the
business to the household sector, government sector, foreign sector, and the capital
markets.

Government Sector;
Receipts – Major sources of income include taxes paid by the household and the business
sector. It also receives interest and dividends for the investment made.
Payments – Makes payments in the form of transfer payments, subsidies, grants, etc. In the
case of a cash deficit, the government borrows from the capital market to maintain a
balance in the economy.

Foreign Sector;
Receipts – Receives income from the business sector in the form of goods and services
imported by the business sector.
Payments – Payments to the business sector from where the imports have been made.
The imports ( M ) constitute the leakages from the circular flow.
The exports ( X ) constitute the injections into the circular flow.

The equilibrium condition in the four-sector model is as follows;

S+T+M=I+G+X

Where,

S = Savings

T = Taxes

M = Imports

I = Investment

G = Government expenditure

X = Exports