Circular flow of income in a two sector model with financial market 

In actual practice , household do not spend their entire income on consumption, i.e., a part of their income is saved. Firms also save some part of their receipts for expansion and other reasons. Firms also borrow money to finance their expansion programs. All savings and borrowings are channelized through a financial market . 

Financial Market refers to institutions such as banks, insurance companies etc. which trasacts in lonable funds. Saving of households accumulated in the financial market are utilised by firms for investment purposes , So the circular flow of income continues.


Circular Flow of income in a 3 sector Economy 

Circular flow of income in a 3 sector economy , consists of households , firms and the government sector. Government acts as both consumer and a firm. As a producer , it produces goods and services for the economy. 

1. Between Firms and Government : Money flows from firms in the form of direct taxes and indirect taxes.

Money flows to the firms from the government when the latter grants subsidies and make payment to the former for purchase of goods and services produced by them . 

2. Between financial markets and Government : A part of the income earned by government is also saved and deposited in the financial market. Government also borrows money from the financial market to meet its expenditure


  • Household - It does only consumption and provide factor services . It also does savings in financial markets. 
  • Firms - It does only production and give factor payments. It also does savings and borrowings from financial markets. 
  • Government - It does taxation and provide subsidies(social transfer) . It does savings and borrowing from financial market. 
  • Financial Market - Accepts savings from households , Government , Firms and provide loans to Firms and government. 


We will study Circular flow in a 4 sector economy in next post . 
  • Financial Market .