Circular Flow of Economic Activity Essay

Custom Student Mr. Teacher ENG 1001-04 30 May 2016

Circular Flow of Economic Activity


To analyze an economy as a whole economists developed different models. The significance of these economic models enable us to understand the economic activities more vividly. For this purpose an economy can be classified in to four major sector. Which includes households, firms, government and foreign sector or external sector. There is a simple model which constitute two sectors, that is households and firms. Its working can be understand with the help ofcircular flow of economic activity of two sector model. Gradually the role of government considered as an important one and the government sector also included to this model. This is popularly known as the three sector model economic activity. But now the four sector model become more important, because almost all the countries are opened and they are actively participating in foreign trade (export and import). So, the four sector model representing an open economy. Here this hub very briefly explained about the interactions between these four sectors and its working.

Four Sectors of an Economy

As mentioned above there are four integral parts or sectors consisting in a four sector model economy. They are house hold sector, firms, government and foreign sector. Each of them are briefly explained below. Household sector : It consist of peoples or individuals. House hold sector provides factors for productions like labor, land, building, capital etc. Consumers are also listed under household sector. Firms : It refers to the various industries which providing goods and services to satisfy the demand of households. Firms are hiring the factor services supplied by households and firms rewarded them in various forms like wages for labor, rent for land and building etc. Government : It is an important part of any economy. The main function of government sector includes policy making, implementation of policies, law and order etc. The government may make fiscal policy or monetary policy. They adjust policy instruments to stabilize the economy.

The instruments may in the form of tax, subsidies, factor payments etc. Foreign sector : foreign sector is an integral one for any open economy. Since the international trade become more active every country take it as a vital one to make policy, improve national growth etc. in an open economy, factor rewards are flowing both in to the economy and out to the economy. Whatever may be the flow of transaction s it will come under the foreign sector or external sector. It includes imports, exports, granting loans between countries, payments for renting services like shipping, air services etc.

The Four Sector Model

The economic activities or interactions between these four sectors of an economy can be explain with the help of a figure as showing below.

Household Sector

Initially household sector provides its factors of productions like land, labor, capital and organizer to the firms. And they will be rewarded by firms in different kinds. That is a labor will earn wage, capital will earn interest, organizer will earn profit and land will earn rent. After making products or output households will demand it and they pay their consumption expenditure. Here the factors of production are supplying through factor market and goods and services (output) are supplying through goods market. Similarly, households interact with government sector in two ways. Firstly, the household sector will pays taxes, which may direct or indirect taxes. Then the government may spend money in the economy for household sector in the forms like pensions, scholarships etc. Household sector interact with foreign sector in two kinds. Household sector receive transfer payments from abroad for providing their services in abroad. When the economy import something households will spend their income on imported goods. So, import is considered as a leakage from the economy.


Firms are producing the goods and services. For that firms are hiring factor services supplied by household sector. After the production process they will sell the output in the goods market or commodity market. So, the firm sector will receive consumption expenditure of household sector. Firms are actively interact with government. Since taxes from business sector is much important for government, it is the expenses of firms and revenue for government. Sometimes government may provide subsidies for business firms by aiming different purposes. So, subsidies are the expenses of government sector and a alms for the business firms. Business firms are very actively interact in foreign sector. The income of firms increase when they export goods and services to abroad. Similarly when theydemand capital goods, machines, raw materials etc, it will consider as an expenditure to the firms.

Government Sector

Government sector interact with household sector by providing transfer payments in the form of pensions, bonus, scholarships etc. Similarly government earn both direct and indirect taxes from household sector. Government sector also earn taxes from firms from their business activities. Above all government provides many assisting support for enriching business sector like granting subsidies, price ceiling etc. Today, every government has a touch with foreigners. They also assisting by providing loans, technical assistance etc. so, there will also be the inflow or outflow of income and output.

Foreign Sector

Foreign sector plays a vital role in an open economy. When household sector demand more, the import will increase and lead to a deficit foreign trade account. On the other hand foreign sector make payments on services provided by household sector in abroad.s Foreign sector pays on commodities exported by firms to abroad. So, it is a injection to the economy. Similarly foreign sector also pays on the service provided by firms in the form of air services, software etc. when tourists visits domestic economy, they will spend money, so it is also an inflow to the economy. Similarly government sector also interact with government. If government make any trade with foreign sector, there will be inflow or outflow of income.


In short, four sector model economy is an open economic model. Which showing a simple picture of the economy and economic activities. In a four sector model economy all the sectors are interacting with each other in many ways. So, it reduce the complexity for understanding the complicated activities.

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  • Date: 30 May 2016

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