Three sector model of circular flow in closed economy.
So far we have been working on the circular flow of a two-sector model of an economy. To this we add the government sector so as to make it a three-sector closed model of circular flow of income and expenditure. For this, we add taxation and government (or expenditure) in our presentation. Taxation is a leakage from the circular flow and government purchases are injections into the circular flow.
First, take the circular flow between the household sector and the government sector. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow.
But the government purchases the services of the households, makes transfer payments in the form of old age pensions, unemployment relief. sickness benefit, etc., and also spends on them to provide certain social services like education, health, housing, water, parks and other facilities. All such expenditures by the government are injections into the circular flow.
Text take the circular flow between the business sector and the government sector. All types of taxes paid by the business sector to the government are leakages from the circular flow. On the other hand, the government purchases all its requirements of goods of all types form the business sector, gives subsidies and makes transfer payments to firms in order to encourage their production. These government expenditures are injections into the circular flow.
Now we take the household, business and government sectors together to show their inflows and outflows in the circular flow. As already noted. taxation is a leakage from the circular flow. It tends to reduce consumption: and saving of the household sector. Reduced consumption, in turn, reduces the sales and incomes of the firms. On the other hand, taxes on business firm tend to reduce their investment and production.
The government offsets these leakages by making purchases from the business sector and buying services of the household sector equal to the amount of taxes. Thus total sales again equal production of firms. In this way, the circular flows of income and expenditure remain in equilibrium.
Taxes flow out of the household and business sectors and go to the government. Now the government makes investment and for this purchases goods from firms and also factors of production from households. Thus government purchases of goods and services are in injection in the circular flow of income and taxes are leakages.
If government purchases exceed net taxes then the government will incur a deficit equal to the difference between the two i.e., government expenditure and taxes. The government finances its deficit by borrowing from the capital market which receives funds from households in the form of saving.
On the other hand, if net taxes exceed government purchases the government will have a budget surplus. In this case, the government reduces the public debt and supplies funds to the capital market which are received by firms.
