Hi,

The circular flow of income or circular flow is a model (https://en.m.wikipedia.org/wiki/Economic_model) of the economy in which the major exchanges are represented as flows of money, goods (https://en.m.wikipedia.org/wiki/Good_(economics)) and services, etc. between economicagents.Four models (Forms) of circular flow of national income and its significance are:

1) Circular Flow of Income in a Two Sector Economy:

Let us start with a simplified model involving two sectors, namely, household sector and firm sector, assuming that there is no government. We further assume that the economy is a closed one having no exports or Imports. Similarly, there is no saving by the households, who spend all what they earn; and no investment by the firms.

2) Introduction of Capital Market (Financial system):

We now drop the above- mentioned assumptions one by one and move a step further by bringing in the role of capital market consisting of financial institutions. Financial institutions are primary intermediaries between savers and investors (or lenders and borrowers). All lendings and borrowings are channeled through capital market. In practical life, whatever is earned by the households is not spent on consumption goods.

3) Introduction of Government Sector (Circular Flow of income in a three sector economy):

We move further by introducing Government Sector which purchases goods from firms and labour services from households. Between households and the government, money flows from government to the households when the government makes transfer payments (like old-age pension, scholarships, etc.) and factor payments (for hiring services of factors of production) to the households. Money flows back to the government when it collects direct taxes (income tax, wealth tax) from the households.

4) Introduction of External Sector (Circular flow of income in a four sector economy):

Our model will remain incomplete without converting the closed economy into an open economy where imports and exports are made. One country’s exports are another country’s imports. With the increase of a country’s imports, money flows to the rest of world (ROW) whereas in the case of exports, money flows in from ROW.

Hope it helps.