The individuals consist of all individuals in the economy and looks at their activities such as earning income and spending it on goods and services. Government makes transfer payments like old age pension, scholarships to households and grants subsidies to firms. Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. Money so received is, in turn, spent by the household sector to by goods produced by the business sector. It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. When the public sector as a whole runs a budget surplus, the direction of the arrow is reversed. For example, factory workers at Raymonds mills produce linen and they get wages.
Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. If exports are equal to the imports, then there exists a balance of trade. Other money is used to buy goods or services produced overseas. Here we will concentrate on its taxing, spending and borrowing roles. Since the households spend their income, the total monetary receipts of business sector will be equal to the income and consumption expenditure of the household sector. Therefore, there is no existence of inventories. The economy contains a special set of institutions whose function is to channel the flow of funds from households, as savers, to firms, as borrowers.
This represents a simple economic model; it is a closed economy without any government intervention. As a result, circular flow of income does not continue at a steady level in a free-enterprise capitalist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy. Financial market invests money by lending out money to households, firms and the government. If value of exports exceeds the value of imports, trade surplus occurs. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Thus seen, i savings and ii taxes by households and firms and iii imports constitute a leakage from the circular flow of income money whereas i investment, ii government expenditure, and iii export payments are injections into the circular flow of income money.
Figure 2 Circular flow - savings and imports S and M are called leakages from the circular flow. Households sell their factor services to firms in the factor markets and in exchange receive wages the left hand side of the flow. They tend to reduce consumption and saving of the household sector. Households and Firms save part of their income and deposit in the capital market leading to money flows from households and firm to capital market. With this money the households purchase from the firms, manufactured goods and services to satisfy their wants with the result, the same money flows back from households to the firm sector. The household sector owns all the factors of production that is land, labor, capital and enterprise. Next take the circular flow between the business sector and the government sector.
Firms also receive subsidies from the government. The businesses use the proceeds from the sales to produce more products and pay workers for their labor. Investment, government spending and spending by foreigners is injected into the tank, and savings, taxes and spending on imports leak out. It deals with individual income, individual prices and individual outputs, etc. The government finances its deficit by borrowing from the capital market which receives funds from the household sector in the form of saving. More so when foreigners invest in our country the level of income will also increase. We could also represent the government separately in this circular flow - here's an alternative representation of Figure 4.
These are firms and households. As long as income payments by the business sector for factor services are returned by the household sector to purchase goods, the circular flow of income payments and consumption expenditure tends to continue indefinitely. On the other hand, purchases of foreign-made goods and services by domestic households are called imports. It is business firms who borrow from the financial market for investment in capital goods such as machines, factories, tools and instruments, trucks. If planned I+G is equal to planned S+T , so that injections is equal to leakages and total spending is equal to total income and total demand is equal to total supply. Therefore income flows from firms to households. The business sector does not keep any undistributed money as reserve.
But the government does not always balance their budgets. When the domestic business firms export goods and services to the foreign markets, injections are made into the circular flow model. If injections are greater than withdrawals or leakages then the level in the tank will rise. The total value of output produced by firms. On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. Thus total sales again equal production of firms. These are the leakages from the circular flow.
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. We now add government sector to the two-sector model of Household and Firm Sector. The money it receives by selling goods and services to the household sector is fully spent in making payments as rent, wages, interest and profits to the household sector. First, we discuss their nature and role in decision-making. We further assume that the economy is a closed one having no exports or imports.
In other words, in our above analysis we have not taken into account the role of foreign trade. So long as the household sector continues spending the entire income in purchasing the goods and services from the business sector, there will be a circular flow of income and production. The various components of national income and expenditure such as saving, investment, taxation, Govt, expenditure, exports, imports, etc. The institutions involved in the borrowing and lending money of money are the financial institutions sector. Even though this partly goes to pay themselves and their bureaucracy, as well as funding schools and hospitals, it finds its way back into the flow. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and import goods and services. Circular Flow of Income in a Four-Sector Economy: Two-sector economy and three-sector economy are briefly discussed in previous sections.