Circular flow of Income and

Expenditure in Closed and

Open Economy
• Economy is an integrated activity for the production, distribution and
consumption. In carrying out these economic activities, people are
involved in making transaction, i.e. buying and selling of goods and
services.

• Economic transactions generate two kinds of flows: flows of goods and

services and flow of money.

• Money flow is the flow of factor incomes in the form of wages and
salaries, rent, profit and interest from the producing sector to the
household sector as the monetary rewards to their factor services.
• On the other hand product or real flow is the flow of factor services from household
sector to the producing sector and corresponding flow of goods and services from
the producing sector to the household sector.

• Product and money flow in the opposite direction.

• For example, when people buy goods and services, they have to pay which is
received by the seller.

• Similarly when producers or firms buy or hire factors of production, they have to
make payment which is received by factor owner.

• Circular flow of income and expenditure is the integrated flow of resources and
goods and services among the different sectors of the economy.
To illustrate the circular flow of income and expenditure the economies are
divided into closed and open economies as follows:

1. Closed Economy

• The economy which has no international trade is called closed economy. Such
economy has no import and export. In other words, such economy has no
economic relations with other countries of the world.

• Closed economics are rarely found in the real world.

• The closed economy can be further divided in to two sector and three sector
economy.
a. Two Sector Economy

• Two Sector Economy Consists of only household and business sector.

It does not consist of Government and Foreign Sector.

b. Three Sector Economy

• The economy which consists of only household, business and

government sector is called three sector Economy. Such economy also
don’t have international trade or economic relation with other
countries of the world.
2.Open Economy

• The economy which consists of household sector, business sector,

government sector and foreign sector is also known as four sector
economy. All economies of the world are open economies.

• The economy is involved in international trade i.e import and export.