Four Sector Open Model of Circular Flow of Income

 Four – Sector Open Model of Circular Flow of Income : Model with Foreign Sector 

•      An open economy is an economy that engages in internationally trade in goods and services. Therefore if needs to be include, the forth sector i.e. Foreign Sector or rest of the world in our model.

 

•    A four sector model comprising households, firms, government and rest of the world or foreign sector is known as an open economy model.

•    Given figure represents an open economy – four sector model of circular flow. To avoid overcrowding the diagram shows only money flow between government , firms and households as well as with rest of the world, but their counterpart real flow in opposite direction should be kept in mind. 

•      The four sector model presents the interaction between the domestic economy and rest of the world through flow of goods and services (international trade) and flow of factor services.

•      The household sector import goods from abroad and make payments to the foreign sector. 

• On the other hand, the household sector receives ‘ foreign remittances’ in foreign exchange by selling some of the factor services abroad. For example, Indian people working abroad may remit income to their families in India.

• This way there is an out flow of money from household to the foreign sector to pay for imported goods and services and inflow of money for the services rendered by them in foreign countries.

•  The business sector exports goods and services ( like shipping, insurance, banking etc.)to foreign countries and receives payment in the form of   ‘receipt from export’. This is the inflow of money expenditure in economy.

•  On the other hand, business sector also imports goods and services from abroad and make payments to the foreign sector. This is the outflow of money from the economy.

• There is also an inflow and outflow of capital services between the government and rest of the world due to export and import of goods and services.

• Imports (M)  causes outflow of income hence it constitute leakage resulting in contraction in the level of circular flow of income.

• While exports (X) causes in flow of income hence it constitute injection resulting in expansion in the level of income in circular flow.

• If the inflow of income is equal to the outflow the level of circular flow would remain unaffected because the contraction of income due to outflow would be offset by expansion of income due to inflow of income from abroad. 

• Therefore the circular flow of income in a four sector open economy model is said to be in equilibrium when –