What is a circular flow of income?

• The circular flow of income shows the

connection or linkages between different
sectors of the economy.
• It can be explained with the help of economic
models.
• The circular flow model
is a picture of market economy in
action. It tells how the money
flows in the economy.
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 Types of circular flow models

• Two sector model

• Three sector model

• Four sector model

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 Two sector model
• It consists of household sector and the
industrial sector.
• Household sector demand goods and services
and they provide labour resources to the
business sector.
• Industrial sector produce and supply goods and
services to the household sector
Businesses demand resources for production: land,
labour, capital, and entrepreneurs.
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 Household sector

Spending

Factor Incomes Products Factor Services

Firms/ industrial sector

Factor Incomes Factor Services
Wages/Salaries Labour
Interest Capital
Profit Entrepreneur
Rent Land 4
 Three sector model
It is called the closed economy model.
It includes the
household sector
industrial sector
government sector – the government collects
taxes to provide resources and services to the people.

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 goods & services… Product
Product ….goods & services
Markets
Markets
….consumption spending….

industrial sector
Household sector

Government sector

….salaries, wages, rent, dividends…..

Factor
Factor
land, labor, capital…… …entrepreneurial ability
Markets
Markets
 goods & services… Product
Product ….goods & services
Markets
Markets
….consumption spending….

industrial sector
Household sector

….salaries, wages, rent, dividends…..

Factor
Factor
land, labor, capital…… …entrepreneurial ability
Markets
Markets
 goods & services… Product
Product ….goods & services
Markets
Markets
….consumption spending….

Personal Income Taxes

industrial sector
Household sector

Corporate Income Taxes

….salaries, wages, rent, dividends…..

Factor
Factor
land, labor, capital…… …entrepreneurial ability
Markets
Markets
 goods & services… Product
Product ….goods & services
Markets
Markets
….consumption spending….

Personal Income Taxes

transfer payments subsidies

industrial sector

Household sector

Corporate Income Taxes

….salaries, wages, rent, dividends…..

Factor
Factor
land, labor, capital…… …entrepreneurial ability
Markets
Markets
• The is called the open economy model.
• It consists of
Four sector model
household sector
industrial sector
government sector
financial sector and the
foreign sector.
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 Uses of circular flow models
• It gives the clear picture of the market
economy.
• It helps in the calculation of national income.
• Formulation of trade policies which promotes
the exports and reduces the imports.
• It explains the importance of monetary policy
by establishing equilibrium between savings
and investment.

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