circular flow of income

An economic model called the circular flow of income shows how money or income flow among the many economic sectors. In a simple economy, households and firms are assumed to be the only two sectors. households are the owners of the production factor and also the consumers of goods and services (capital, land, labour, enterprise). However, the producing sector produces and distributes (sells) goods and services to households.

e exchanges of goods and services between the two Sectors (Producing sectors and Household Sectors) in the circular flow of income generate a particular flow of income in an economy. Consumers spend their income on the consumption of these goods and services, while households provide the firm with the factors of production (capital, land, labour, enterprise) that produce the products and services. In the form of rent, Interests, wages, and profit. The firms then provide factor payments to the Households sectors.  this Exchange of products and services such as factor payments between the producing sectors and household sectors the circular flow of income in an economy.

What is a circular flow of income?

The Primary concerns of economies are explored by macroeconomics. the most important of these is how economies produce wealth. All Factors of Production in an economy go through a production flow of income or cycle, which creates wealth in the form of factor payments, which are payments made to the factor of production. Therefore, producing this flow and producing commodities that are subsequently consumed by consumers who spend their income on such goods and services is how countries’ economic wealth is produced.

sectors of Circular Flow of Income

Two Sector Economy, Circular Flow (With Financial Market)

It Is considered that there are no savings in the economy in the circular flow of a two sector economy without the financial market. This means that each household uses all its money to pay for products and services, and each firm uses all of its sales income to pay factor payments.

In the actual world, households do not expend their entire income on the buying of goods and services, so this does not happen. instead, they set aside some of their salaries as savings. similar to this, businesses set aside a part of their receipts for various purposes, including business expansion. Also, the businesses borrow money from other sources to pay for their expansion plans. the financial market is the funnel through which the economy’s savings and borrowings are transported. As a result, in a two sector economy, the enterprises use household resources that have been collected on the financial market for investment.

The diagram that follows can help you better understand this: –


Two-Sector Economy, Circular Flow

Three sector economy, circular flow

The government is necessary for a country’s economic growth. In a three sector economy, the circular flow of income includes households, companies, and the people sector. A country’s government served as both a company and a consumer. the government provides goods and services for a company as a company or producer. It spends money on purchasing the goods and services provided by a company as a consumer. the additional flow set interaction of the government includes, in addition to the circular income flows in the two sector economy with such a financial market, the followings: –

  1. Households and Government
  2. Firms and Government

Households and Government

Here are the two forms that the governments transfer funds to individual households in an economy.  1st, through transfer payments – pension payments, scholarships, etc. 2nd, In the form of factor payments for household’s factors services. Household Sectors submit this money to the governments in the form of direct taxes – income taxes, interest taxes, and others.

Firms and Government

Indirect taxes and direct taxes are the key methods by that companies contribute money to the governments in an economy. The government’s funding for companies enters an economy in the type of subsidies. In these cases, the governments provide subsidies to the company and pay them for the goods and services they buy.

The financial market also has to play an important contribution in a three sector economy. As the government saves some of its earned money and invests it there. In fact, governments borrow money from the banking sector to cover their expenditures.

The diagram that follows can help you better understand this: –

Three-sector economy, circular flow

Four Sector economy, circular flow

In Additional to the Household sector, firms, the government sector, and the foreign sector are crucial to an economy. There is a four sector economy, the circular flow is made up of households, Firms, the foreign sector, and the government sectors. These sectors’ single money flows are as follows: –

  1. Household Sector
  2. Firms
  3. Governments Sector
  4. Foreign Sector

Household Sector

The domestic sector of an economy provides factor services to firms, the government, and the foreign sector, in return for which it receives factor payments. In addition to factor payments, households also receive a number of payments from the government and the foreign sector such as transfers as scholarships, old age pensions, etc. The domestic sector spends its earned income on paying for goods and services purchased from firms, paying for imports, and paying taxes to the government.

Firm Sector

Firms receive revenue for the sale of goods and services from the government, households, and foreign territories. They also get subsidies from the government for the production of goods and services. In addition, companies pay the government for taxes, imports into foreign territories, and factor services to households.

Governments Sector

The government receives revenue from the sale of goods and services, duties, taxes, etc., by firms, households, and the foreign sector. It also creates some factor payments to households. The government spends its revenue on transfer payments and subsidies.

Foreign Sector

The foreign sector receives revenue for the export of goods and services from the firm sector, household sectors, and the government. It also pays the government, firms for the import of goods and services, and households for factor services.

The financial market also plays an important role in a four sector economy as savings by households, firms, and the government is deposited here. This money is invested by the financial market in the form of firms, households, and loans. government. In a four sector economy, the inflow of money equals the outflow of money into the financial market, making the circular flow of income complete and continuous.


The diagram that follows can help you better understand the four sector economy this: –

Four Sector economy, circular flow