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Ogbinar, Jessica Marie
AE 113 MT 11:30-1:30
Circular flow of income is a model of the movement of spending and income between
firms/producers and household, that we also use to measure economic growth, such model is called
two-sector economy as it only considers two sectors which are household and firms. Firms provides
goods and services and they require various resources to produce these goods and services .
Households provide these resources that are needed for production. For example, a household
provides land and labor to carry out business operations in exchange for the money paid in rent,
wages, etc. These wages and rent are used by the households to purchase goods and services to fulfill
their needs and wants and the money that they pay will now flows back to the firms, completing the
circular flow of income.
For a macro-level understanding, the two-sector model is not sufficient as other factors are not
considered to explain the flow of income and expenditure. The factors include, the role of the
government,foreign trade, and the financial sector. The three, four sector or seven five sector
economy models respectively look at such issues.
In the three-sector model, the government is added to the two-sector model. In this model, money
flows from households and businesses to the government in the form of taxes. The government pays
back in the form of government expenditures through subsidies, benefit programs, public services, etc.
The four-sector model contains the foreign sector, which is also known as the overseas sector or
external sector. The overseas sector turns a closed economy into an open economy. It is connected to
the other sectors through two flows of money: foreign trade (imports and exports) and foreign
exchange (inflow and outflow of capital). Like the other sectors, each flow of money is paired with a
flow of a factor of production or goods and services.
The fifth sector – the financial sector – is added to complete the circular flow model. It includes banks
and other institutions that provide borrowing and lending services to the other sectors. Savings and
investments are assumed in the five-sector model, which flow from other sectors with residual cash
into the financial institutions, then out to the sectors that need money. As long as lending (injection)
is equal to borrowing (leakage), the circular flow reaches an equilibrium and can continue forever.
References:
https://saylordotorg.github.io/text_economics-theory-through-
applications/s35-27-the-circular-flow-of-income.html
