Circular Flow of Income and Expenditure in Three Sector and Four Sector Economy

Circular flow of income and expenditure in three sector economy

The three sector economy is the addition of government’s income and expenditure in two sector economic model. The model is considered more realistic than the two sector economy as it incorporates the role of government in economic activities. This model is also a closed economic model as it does not include foreign sector in the economy. The government’s intervention in national economy emerged particularly after the great depression of the 1930s. The devastating situation of great depression gave rise to the concept that the government’s intervention in the economy is important and necessary. However, in reality, the increase in government’s role in the economy was observed during post-world war II period.

The inclusion of government in the model requires the income and expenditure of government. The income of government is represented by the taxation policy while the expenditure is represented by expenditure on goods and services, subsidies and transfer payments. These transactions have different types of effect on income and expenditure flow.

The circular flow diagram of income and expenditure in three sector economy is presented below. The figure presents only money flow to and from the government while the real flow of goods has been excluded in order to remove the overcrowding of diagram. It must be noted that each money flow except transfer payments has a counter flow in the form of goods flow.

As compared to the two sectors economic model, the magnitude of flows between households and firms gets reduce because a part of their income goes to the government sector. Income flows from household sectors and firms to the government sector in the form of taxes. The income received by the government sector in the form of tax flows to the business sector in the form of government expenditure on goods and services and to the household sector in the form of remuneration for the factor services rendered to the government. The government also gives subsidies to the business sector and pensions, etc. to the household sector in the form of transfer payments. Thus, the money that flows from the households and the firms to the government in the form of taxes flows back to these sectors in the form of government expenditure. A certain part of income earned by household is saved and deposited in capital market which is invested by the firms in productive sectors.

Leakages and injections in three sector economy

Taxes are the withdrawals (leakages) from the income flows because they reduce private disposable income which in turn reduces consumption expenditure and savings. On the other hand, investment expenditure by government and firms is an injection to income flow. The transfer payments by the government (e.g., old age pensions, subsidies, unemployment allowances, etc.) are injections to the circular flow. They cause an increase in household income which increases the consumption expenditure of households in consumer goods.

Circular flow of income and expenditure in four-sector economy

It is a real model of the circular flow of income and expenditure. This mode is formed by adding foreign sector to the three-sector model. It studies the circular flow in an open economy. An open economy comprises of four sectors: (1) Household sector (2) Business sector (3) Government sector and (4) Foreign sector. The foreign sector consists of two kinds of international transactions: (i) foreign trade, that is, export and import of goods and services and (ii) inflow and outflow of capital. In reality, every economy has four sectors. This model studies all sectors of economy dropping all simplifying assumptions made for two and three sector models.

This model is explained on the basis of following assumptions:

1. The foreign sector consists of only imports and exports of goods and services.
2. The export of goods and non-labor services are made only by firms.
3. The households export only labor.

Circular flow of income in four-sector economy is described below with diagram:

1. Household sector: The receipts and payments of household sector are described below:

i. Receipts: The household sector receives factor income from the business sector and transfer payments from the government sector. There is the flow of income to household sector in the form of transfer payments and factor income.

ii. Payments: The household sector makes payment to the business sector for buying goods and services. It also pays direct taxes to the government sector. Saving of this sector flows into the capital market.

2. Business sector: The receipts and payments of business sector are described below:

i. Receipts: Business sector receives its income from household by selling goods and services and from the government through government purchases and subsidies. Similarly, it also receives income from the foreign sector in return in return for its exports.

ii. Payments: The business sector makes factor payments to the household for using the factor services. It pays taxes to the government. Payments are made to the foreign sector for imports.

3. Government sector: The receipts and payments of government are described below:

i. Receipts: Government receives direct taxes from households and direct and indirect taxes from business firms.

ii. Payments: Government makes purchases to firms for goods and services. Similarly, it also gives subsidies to the business firms. It also spends money on the household for wages, salaries,
and transfer payments.

4. Foreign sector: The receipts and payments of foreign sector are described below:

i. Receipts: The foreign sector receives income as payments of import from the business firms and hence the money flows from foreign sector to the business firms.

ii. Payments: Similarly, the foreign sector makes payment to the business sector for the purchase of goods and services exported by the business sector.

5. Capital market
The household sector, business and government do not spend all of their income. They save part of their income for any unforeseen activities. This saving is deposited in the capital market.

Injections and leakages in four-sector economy

Exports make goods and services flow out of the country and make money flow in the country the form of receipts of exports. This is the flow of foreign income into the economy. Exports represent injection into the economy. On the other hand, imports make inflow of goods and services and flow of money out of the economy. This is the flow of money out of the country. Imports represent leakages from the circular flow.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.