When a producer produces a product or service with the help of different factors of production like labour, capital, land, etc., and after production, payment is made to each factor in terms of rent, wages, interest of production, this process creates a circular flow of income in the economy.
Different model of circular flow of income
1. Two sector economy
In the two-sector model, flow of goods and service and money occurs between two sectors only, that is, the producer sector and household sector. This model is explained with the help of the given diagram:
2. Three sector economy
In the three-sector economy model, there are three sectors present in the economy, namely the producer sector, Household sector and the Government. The flow of income and Goods and service will take place between these three sectors. The three and two sector models represent a closed economy since the economy does not engage in foreing trade with other economies.
3. Four sector economy
In the four-sector economy model, the economy is no more a closed economy as we saw in previous models. According to this model, the economy is open to the rest of the world for trade. So, in this model the four sectors in action are, producer sector, household sector, government and foreign sector.