Explain circular flows of income in (i) two-sector economy, (ii) three-sector economy, and (iii) four-sector economy.

The structure of macroeconomy is given by circular flows of income and output. In fact national income accounting has its foundation in the model of circular flows which can be depicted in two-sector, three-sector and four-sector models as explained below.

(a) Circular Flow of Income in a Two-sector Economy. Let us start with a simplified model involving two sectors, namely, household sector and firm sector, assuming that there is no Govt. We further assume that the economy is a closed one having no exports or imports. Similarly there is no saving by the households, who spend all what they earn; and no investment by the firms. Such an economy has two types of markets — Product market and Factor market. Under these presumptions the firm sector hires factor services from households, who are owners of factors of production (land, labour, capital and enterprise), for producing goods and services and pays them remuneration (or compensation) in the form of money for rendering the productive services. For the factors of production, these are factor incomes known as rent, wages, interest and profit which have been generated in the production process. Thus money income flows from firm sector to the households. 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. Thus entire income of economy comes back to firms in the form of sales revenue. Clearly one man's (or sector's) expenditure is other man's (or sector's) income. The counter flow of money from households to the firms leading to the circular flow of money between the two sectors is shown in the following Fig.(a).

Fig. (a)
Circular flow of income with capital market (Financial System). We bring the role of capital market consisting of financial institutions. Financial institutions are primary intermediaries between savers and investors (or lenders or borrowers). 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. This constitute a leakage from the circular flow of money. Firms also borrow for purposes of investment. This becomes injection in circular flow as shown in Fig.(b).

Fig.(b).
Leakages and Injections. A leakage is the amount of money which is withdrawn from its flow of income. As against it, injections are the amount of money which is added to the flow of income in the economy. 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).
(b) Circular flow of income in a three-sector economy. We now add government sector to the two-sector model of Household and Firm Sector. Government purchases goods from firms and labour services from households. It collects corporate taxes from firms and personal taxes (income tax, wealth tax) from households. Government makes transfer payments (like old age pension, scholarships) to households and grants subsidies to firms.
All these cause flow of money which are shown in Fig.(c).

Fig.(c).
But from macroeconomic point of view, there are four sectors, namely, 1. Households, 2. Firms, 3. Government, and 4. External sector.

(c) Circular flow of income in four-sector economy. Without introducing external sector (also called Rest of World — ROW), our model will remain incomplete. The domestic economy is connected with ROW through international trade (imports and exports) and capital flows. In case of imports, money flows to the ROW whereas in case of exports money flows in from ROW. Mind, imports are leakages and exports are injections into the circular flows of income in the economy. The four-sector model of the economy is fully depicted in Fig.(c).
Significance of circular flow of income (i) It reflects structure of an economy. (ii) It shows interdependence among different sectors. (iii) It gives information about injections and leakages from flow of money. (iv) It helps in estimation of national income and its related aggregates.