Circular Flow of Income
The circular flow of income is a model of an economy showing
connections between different sectors of an economy. It shows flows of income,
goods and services and factors of production between economic agents such as
firms, households, government and nations. The circular flow analysis is the
basis of national accounts and macroeconomics.
There are three models of circular flow of income, representing
the major economic systems.
1. Two Sector Model: It is for a simple economy with
households and firms.
2. Three Sector Model: It is for a mixed and closed economy with
households, firms and government.
3. Four Sector Model: It is for an open economy with
households, firms, government and rest of the world (External sector).
There are only two sectors namely, household sector and firm
(i) Household Sector: The household sector is the sole buyer of
goods and services, and the sole supplier of factors of production, i.e., land,
labour, capital and organisation. It spends its entire income on the purchase
of goods and services produced by the business sector. The household sector
receives income from firm sector by providing the factors of production owned
(ii) Firms: The firm sector generates its revenue by selling goods and
services to the household sector. It hires the factors of production, i.e.,
land, labour, capital and organisation, owned by the household sector. The firm
sector sells the entire output to households.
In a two- sector economy, production and sales are equal and there
will be a circular flow of income and goods. The outer circle represents real
flow (factors and goods) and the inner circle represents the monetary flow
(factor prices and commodity prices). Real flow indicates the factor services
flow from household sector to the business sector, and goods and services flow
from business sector to the household. The basic identities of the two-sector
economy are as under:
Y is Income; C is Consumption; I is investment
In addition to household and firms, inclusion of the government sector makes this model a three-sector model. The government levies taxes on households and firms,purchases goods and services from firms, and receive factors of production from household sector. On the other hand, the government also makes social transfers such as pension, relief, subsidies to the households. Similarly, Government pays the firms for the purchases of goods and services.
The Flow Chart illustrates three-sector economy model:
Under three sector model, national income (Y) is obtained by
adding Consumption expenditure (C), Investment expenditure (I) and Government
In a Four- sector economy, in addition to household, firms and
government, a fourth sector namely, external sector is included. In real life,
only four-sector economy exists. This model is composed of four sectors namely,
(iii) Government, (iv) External sector
The external sector comprises exports and imports. It is
illustrated in the Flow Chart.
In four-sector economy, expenditure for the entire economy include
domestic expenditure (C+I+G) and net exports (X– M). Therefore,
Y = C + I + G + (X – M)