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Circular Flow Model

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What is the four sector circular flow model? A circular flow of income is a four-sector economy which includes households, firms, government and foreign sector. The circular flow of income indicates connections between various areas of our economic system. It revolves around flows of goods and services and factors of production between firms and households.

Household Sector

Households provides factor services to firms, government and foreign sector. In return, the households receive factor payments. They also receive transfer payments from the government and the foreign sector. They also spend their income on payment for goods, services that are purchased from firms, taxes for government and payments for imports.

Firms

Firms receive revenue from households, government and the foreign sector for sale of their goods and services. Firms also receive subsidies from the government. Firms, like households also pay taxes to the government. They also make payments for factor services to households and imports to the foreign sectors.

Government

Government receives revenue from firms, households and the foreign sector for sale of goods and services, taxes and fees. Government makes factor payments to households and also spends money on transfer payments and subsidies.

Foreign Sector

Foreign sector receives revenue from firms, households and government for export of goods and services. It makes payments for import of goods and services from firms and the government. It also makes payment for the factor services to the households. The savings of households, firms and the government sector get accumulated in the financial market. Financial market invests money by lending out money to households, firms and the government. The inflows of money in the financial market are equal to outflows of money. It makes the circular flow of income complete and continuous. Withdrawals There can be withdrawals or leakages from the circular flow as not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be put aside for future spending, for example, savings (S) in banks accounts and other types of deposit, paid to the government in taxation (T) e.g. income tax and national insurance and spent on foreign-made goods and services, i.e. imports (M) which flow into the economy. Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output).

Injections

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output. Three examples of injections are Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology, The government, i.e. government expenditure (G) e.g. on the NHS or defense and Overseas consumers buying UK goods and service, i.e. UK export expenditure (X).

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