Presentation_Circular flow_EEP

8/7/2019 Presentation_Circular flow_EEP

http://slidepdf.com/reader/full/presentationcircular-floweep 1/7



2

The circular flow of economic activity can be better

explained under three important headings such as:

Two sector closed economy: Household andbusiness sector.

Three sector Economy: Interrelation between

household, business sector and Government.

Four sector open economy: Household, business

sector, Government and the Overseas sector (import

and export).

Two Sector Closed EconomyAssumptions:

(a) The economy consists only two sectors: household

and business sector or firm.



3

(b) Whatever money the household sector receives, the whole of it is

spent on consumption expenditure.

(c) Whatever income the business sector gets by selling goods and

services, the whole of it is spent on making factor payments.

(d) The business sector and the household sector do not save any

money and also do not pay any tax to the government.

(e) The economy is a closed one, i.e. it does not have trade relations with

the rest of the world.

Diagram:



4

Three Sector Economy.The model presented above is highly simplified case. In fact the economy

is not at all closed one as depicted above and the government is there tointerfere in the business process among household and business sectors,

which leads to the three sector economy with government interference.

In three sector model, we now add the government sector . Households in

this model are required to pay taxes. When the government receives

these taxes they then spend them (government spending) on building

roads, paying soldiers, teachers and so on.



5

Four Sector Open Economy Model

The previous models all assumed that the economy was

closed, i.e., no foreign trade occurred. When we add overseas sector the model is called an open

model.

The four sector model includes foreign trade and transactions

taking place in foreign trade sector .



6

When the household sector purchases goods abroad and

imports them into the economy, the expenditure represents

a leakage (Imports) from the circular flow.

This leakage (import expenditure) has to be balanced by the

export of goods and services which give rise to injections

(export expenditure) to the domestic economy.

When these flows are added to the circular flow activity, we

treat import as leakages and export as injections.

To balance the economic activity of a nation, the

leakages must be equal to the injections.

However, in the four sector open model, leakages would

consists of imports besides savings and taxes and injectionswould consists of exports investment and government

expenditure.



7

What is required at the macro economic level is that the

circular flow activities must be so adjusted that the

aggregate expenditure incurred must equal to the

aggregate income of the economy.

The compilation of three models can be shown in one

diagram as:

Documents

Presentation_Circular flow_EEP