Dr. U.B. Raju

*Compiled from different published sources

*Strictly for academic purpose and for restricted private circulation

3. Income determination in a Four Sector Model

Circular Flow of Income

Circular Flow – 2 Sector model

ConsumersConsumers ProducersProducers

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

Labour, Land, Capital and Enterprise

Goods and Services

Factors of production

Circular Flow of Income2 Sector model

ConsumersConsumers ProducersProducers

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

(Figure 1)

Circular Flow – 3 Sector modelFinancial sector - with Savings as a leakage

ConsumersConsumers ProducersProducers

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

Savings (S)Savings (S)

Financial Sector

Circular Flow – 3 Sector modelFinancial sector

ConsumersConsumers ProducersProducers

Consumption spending (C)

Income (Y) – Wages, Salaries, Rent, Interest & Profit

Savings (S)Savings (S) Investment (I)Investment (I)

Financial Sector(Figure 2)

Circular Flow of Income

• As long as Savings equals Investment the economy will not expand or contract

• S = I

• If Savings is larger than Investment the leakage will contract the economy

• S > I

• If Investment is larger than Savings then the economy will expand (There is an injection of extra funds)

• S < I

(Think of a balloon leaking air or being blown up)

Circular Flow of Income

Four Sector Model Consumers, Producers, Financial and “Government”

Consumers Producers

Government SectorTaxation

Consumption spending (C)

Income (Y)

Circular Flow of IncomeFour Sector Model

Consumers, Producers, Financial and “Government”

Consumers Producers

Government Sector

Consumption spending (C)

Income (Y)

Circular Flow of Income

Four Sector Model Consumers, Producers, Financial and Government Sectors

Consumers Producers

Savings (S)

Government Sector

Investment (I)

Consumption spending (C)

Income (Y)

Taxation (T)

GovernmentSpending (G)

(Figure 3)

Circular Flow of Income

• As long as Taxation equals Government Spending the economy will not expand or contract

• If Taxation is larger than Government Spending there is a leakage and the economy will contract

• If Taxation is less than Government Spending there is a injection into the economy and it will expand

Circular Flow of Income

Five Sector Model Consumers, Producers, Financial, Government and Overseas

Consumers Producers

Overseas Sector (O/S)Imports (M)

Consumption spending (C)

Income (Y)

Circular Flow of Income

Five Sector Model Consumers, Producers, Financial, Government and Overseas

Consumers Producers

Overseas SectorImports (M) Exports (X)

Consumption spending (C)

Income (Y)

Circular Flow of Income

Five Sector Model Consumers, Producers, Financial, Government and Overseas

Consumers Producers

Savings (S)

Government Sector

Investment (I)

Taxation (T) Spending (G)

Overseas SectorImports (M) Exports (X)

Consumption spending (C)

Income (Y)

(Figure 4)

Circular Flow of Income

• Savings, Taxation and Imports are leakages• Investment, Govt. Spending and Exports are

injections into the economy• Savings and Investments can be altered by the

Reserve Bank’s control of interest rates• Taxation and Govt. Spending can be adjusted by

the Govt.’s Budget.• Imports and Exports is very difficult to make

adjustments – market forces prevail.

Circular Flow of Spending and Income