Circular Flow of Income in a Four Sector Model

Circular Flow of Income:

The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange. Money has facilitated the process of exchange. Money has facilitated the process of exchange and has removed the difficulties of the barter system. Thus money acts as a medium of exchange. The households supply the economic resources or factors to the productive firms and receive in return the payments in terms of money corresponding to the flows of economic resources and the flows of goods and services. But each money flow is in the opposite direction to the real flow.

Circular Income Flow in a Four-Sector Economy:

The circular flow of income and expenditure for a two-sector and three-sector model is the case of a closed economy. But the actual economy is an open one where foreign trade plays an important role. Exports are injections or inflows into the economy. They create incomes for domestic firms. When foreigners buy goods and services produced by domestic firms, they are exports in the circular flow of income. On the other hand, imports are leakages from the circular flow. They are expenditures incurred by the household sector to purchase goods from foreign countries. 

Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from abroad and makes payments, which is a leakage from the circular flow. In addition, the households may receive transfer payments from the foreign sector for their services in foreign countries. On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Similarly, there are many services rendered by business firms to foreign countries, such as shipping, insurance, banking, etc., for which they receive payments from abroad. They also receive royalties, interests, dividends, profits, etc., for investments made in foreign countries. On the other hand, the business sector makes payments to the foreign sector for the import of capital goods, machinery, raw materials, consumer goods, and services from abroad. These are the leakages from the circular flow.

Like the business sector, the modern government also export and import goods and services, and lend to and borrow from foreign countries. For all exports of goods, the government receives payments from abroad. Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education, etc. and also when the government provides shipping, insurance and banking services to foreigners through the state-owned agencies. It also receives royalties, interest, dividends etc., for investments made abroad. These are injections into the circular flow. On the other hand, the leakages are payments made for the purchase of goods and services to foreigners.

The circular flow of the four-sector open economy with savings, taxes and imports shown as leakages from the circular flow on the right-hand side of the figure, and investment, government purchases and exports as injections into the circular flow on the left side of the figure. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors-the household, the business and the government. These outflows and inflows pass through the foreign sector, also called the “Balance of Payments Sector”.

If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance of payments. But in the long run, exports of an economy must balance its imports. This is achieved by the foreign trade policies adopted by the economy.

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