Question

Draw a well labelled diagram and explain the circular flow of income in a four-sector model.

Answer 1

The four-sector model of the circular flow of income comprises four major sectors: households, enterprises, government and the foreign sector.

In this approach households contribute work to businesses and the government in exchange for wages, salaries and transfers. They spend a portion of their income on goods and services created by businesses, the remainder on taxes and savings and some may be spent on foreign imports.

Businesses create goods and services, pay wages to employees, pay taxes to the government, invest in capital and may export to overseas markets. The government collects taxes from individuals and corporations and uses the proceeds to fund public services, transfers and subsidies. The foreign sector interacts with the domestic economy through exports and imports, which influence the trade balance.

Money moves between different sectors in exchange for labour, goods, services and financial assets, demonstrating how income is distributed throughout the economy.

In the model, Savings + Tax + Imports = Investment + Government Expenditure + Exports, where Savings, Tax and Imports are economic leakages while investment, government expenditure and exports are economic injections.