DIFFERENT MODELS OF CIRCULAR FLOW OF INCOME

Two-Sector Model of the Circular Flow
Under this model circular flow of income between two sectors of the economy (Household Sector & Producing Sectors) are studied.
Assumptions
1) There are only two sectors in economy- Producing sector & Household sector. Producing Sector produces the final products and services by making use of the factor services. Household Sector provides factor services to producing sector and consumes final goods and services produced by it.
2) Government has no influence over the economic activities.
3) Closed economy (there are no export or import activities).
4) Household sector spend all its entire income.
                 
-          In the upper part of this figure, factor services (land, labour, capital etc.) flow from households to producing sector. In opposite direction to this, money flows from producing sector to the households as factor payments (wages, rent, interest and profits).
-          In the lower part of the figure, money flows from households to producing sector as consumption expenditure made by the households on the goods and services, while the flow of goods and services is in opposite direction from producing sector to households.
Since households spend their entire income, Monetary receipts of the producers = Income of households = Consumption expenditure of the households. In this way, total demand of the economy = total supply. This position is called Equilibrium.

Two Sector Model with Savings and Investment
In reality, the household sector does not spend all its income and saves some part of it. The total income of household sector will not reach the producing sector in the form of consumption expenditure. Household sector deposit their savings with financial markets such as banks, insurance companies etc. The producing sector borrows from financial market to expand their productive capacities. Thus, savings are again brought into expenditure stream.
                     
Three Sector Model of the Circular Flow of Income
This model is close to the reality. In this model, we assume that economy is closed economy but government activities are also considered. But circular flow of income is not influenced by the foreign sector at all.
-          Income flows from producing sectors and household sectors to the government sector in the form of taxes
-          The income received by the government sector in the form of taxes flows to producing sector in the form of government expenditure on goods and services. Government also gives subsidies to the producing sector and transfer payments to the household sector. The part of income earned by the government is saved and deposited in the capital market.
-          Government also takes loan from capital market to meet its current expenditure or to invest in development projects.

-          So, income flows into government sector in the form of tax revenue & income flows into producing and household sector in the form of government expenditure.

        
                               

                
Four Sector Model of the Circular Flow of Income
It is a complete model of circular flow of income as it studies circular flow of income in open economy. An open economy consists of four sectors- 1) Household Sector 2) Producing Sector 3) Government Sector 4) Rest of the World Sector.
               

From the point of view of circular flow of income, each sector plays a dual role i.e. it receives certain payments from the other sectors as well as makes certain payments to other sectors of economy. Circular flow of income in different sectors can be expressed in the following manners.
Sectors
Receipts
Payments
1)      Household Sector
-          Factor income (wages, rent, interest and profit) from producing sector
-          Transfer payment from government (scholarship, old age pension etc.)
-          Makes payment to producing sector for purchasing goods and services.
-          Pays direct taxes to government sector
-          Savings flows into capital market.
2)      Producing Sector
-          Receives income from household and government sector in return of goods and services.
-          Income from rest of the world for its exports
-          Subsidies from government sector to increase production
-          Loan from capital market
-          Payment to household sector for using factor services
-          Taxes to government sector
-          Payment to rest of the world for its imports
-          Savings flow into capital market
3)      Government Sector
-          Receives direct taxes from the household sector and indirect taxes from producing sector.
-          Payment to household sector in form of old-age pension, scholarship etc.
-          Payment to producing sector for the purchase of goods and services
-          Payment to producing sector by way of subsidies.
-          As receipts of government sector is more than its payments, surplus goes to capital market.
4)      Rest of the world Sector
-          Receives income from producing sector for its export
-          Payment to rest of the world for its import


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