CIRCULAR FLOW OF INCOME AND EXPENDITURE
2. iN THE THREE SECTOR ECONOMY
Three sector economy consist of household, business, and government sector. It is also known as a three-sector closed economy. It is more realistic than a two-sector economy as it includes government which plays important role in the economy Although, such kinds of economies rarely exist in the modern global world.
The circular flow of income and expenditure in the three-sector economy is based on the following assumptions:
- The economy consists of households, businesses, and government sectors.
- There is government intervention.
- Government imposes taxes and grants subsidies.
- There is a perfectly competitive market.
- The economy has no international trade i.e., no export and import.
- The business sector pays both direct and indirect tax to the government.
- The household sector pays only direct tax to the government.
On the basis of the above assumptions, we can illustrate the circular flow of income and expenditure in the following diagram:
The figure shows the circular flow of income and expenditure in the three-sector closed economy, where there are household, business, and government sectors.
In the upper half of the figure, households are paid for their factor services and the government receives direct taxes from the households. Similarly, the government imposes both direct and indirect taxes on business firms. The total sum of direct and indirect taxes is the revenue of the government. The government spends this revenue which is received by the households as the wages, salaries, and transfer payments, and business firms as the payment for goods and services and subsidies.