The circular flow model in four sector economy provides a realistic picture of the circular flow in an economy. Four sector model studies the circular flow in an open economy which comprises of the household sector, business sector, government sector, and foreign sector.
The foreign sector has an important role in the economy. When the domestic business firms export goods and services to the foreign markets, injections are made into the circular flow model. On the other hand, when the domestic households, firms or the government imports something from the foreign sector, leakage occurs in the circular flow model.
The circular flow of income in four sector economy can be explained by the flowing diagram:
From the viewpoint of the circular flow of income, each sector has dual roles to play in the economy; while a sector receives certain payments from other sectors, it pays back to those sectors as well. The circular flow of income in different sectors can be expressed as follows:
The household sector receives factor income in the form of rent, wages, interest, and profit from the business sector. It also receives transfer payments from the government sector.
The income of the household sector flows into the business sector, government sector and capital markets in the form of consumption expenditure, taxes and savings respectively.
The principle receipts of the business sector constitute of income from the sale of goods and services, income from exports, subsidies from the government sector, and borrowings from the capital market.
Factor payments, import payments, and savings constitute the principal payments from the business sector to the household sector, government sector, foreign sector and the capital market.
The major source of income for the government sector include the taxes paid by household and business sector. Besides this, it also receives interests and dividends for the investments made.
The government sectors make payments to different sectors in the form of transfer payments, subsidies, grants, etc. It pays to the business sector in return for the goods purchased, makes transfer payments like pension funds, scholarships, etc. to the household sector. If the government receipts are greater than the expenses, the surplus goes to capital market. In case of cash deficit, the government borrows from the capital market to maintain a balance in the economy.
The foreign sector receives income from the business sector in return for the goods and services imported by the latter.
Foreign sectors need to make payment to the business sector from where imports have been made.
If exports exceed imports, the economy has a surplus balance of payment. In case exports exceed imports, the economy faces a deficit balance of payment. Depending on the trade policies, the economy tries to maintain a balance between imports and exports.
Household, business, and government sectors deposit their excess of income to the capital markets as savings. These savings are borrowed by the business sector or government sector for making investments in different projects.
The model can be described using the equation
Y= C + I + G
Where Y= produced goods and services; C= consumption expenditure; G= government expenditure.
Introducing taxation in the model to equate the government expenditure, we get
Y= C + S + T
Where, S= Saving; T= Taxation
Equating the two equations, we get
C + I + G = C + S + T
This results to: I + G = S + T
Introducing foreign sector, we segregate investment into domestic investment (ID) and foreign investment (IF) and get
ID + IF + G = S + T
If IF = X-M
Where X= Exports; M= Imports;
ID + (X-M) + G= S + T
ID + (X-M) + G= S + (T-G)
This equation shows equilibrium in the circular flow of income and expenditure.