Four Sector Economy:

CHAPTER TWO
LECTURE BY: KAMAL REGMI

MEANING OF CLOSED AND OPEN ECONOMY:

Closed economy:

An economy which has no economic relations with

other countries is termed as closed economy in
economics. Two sector and three sector economy are
the examples of closed economy.
The main features of closed economy are as follows:

A closed economy has no export and import and relations

with rest of the world.
In closed economy. We can understand the interrelationhship
between production, consumption and capital formation in a
better way.
In the world of closed economy, there is no place of
international specialization and international trade.
Sometimes,for the simplification of analysis economists
make the assumption of closed economy.

Open Economy:

An economy which has economic relations

with other countries of the world is termed
as open economy. Four sector economy is
the example of open economy.
The main features of open economy are as
follows:

An open economy has open economic relations with

other
countries
which
affect
production,consumption,and capital formation of the
country.
Selling and purchasing of goods and services in the
world market.
Selling and purchasing of shares in the foreign
market.
Lending to foreigners and borrowing from foreigners.

CIRCULAR FLOW OF INCOME AND EXPENDITURE

Flow of goods and services and factor payments among

different sectors of the economy is called as Circular flow
of income.
In other words, it is the flow of payments and receipts for
goods and services between different sectors of the
economy.
Production gives rise to income, income gives rise to
expenditure and expenditure again gives rise to income.
It is the main functional basis of the circular flow of
income.

It is the flow of Production, Income and Expenditure.

It consists of two flows: Real flow and Monetary flow.

REAL FLOW AND MONETARY FLOW:

Flow of land, labor, capital and enterprise by

household sector. Flow of goods and services by
Production sector to meet the demand of the
households as such flow of goods, services and
factor services is known as real flow.
In modern economy, goods, services and factor
services are valued in terms of money.
Household receive rent for their land, wages fro
their labor,interest for their capital and profit for
their enterprise. The flow of money as payments
for goods, services and services is known as
monetary flow.

CIRCULAR FLOW OF INCOME AND EXPENDITURE

IN TWO SECTOR ECONOMY

Two sector economy is closed economy or Market

Economy, where only two sectors i.e. Household
sector and Business Sector are operating without
the active role of the Government.
Business sector/Production sector hires factor
services from household sector and for this
household sector receive factor payments.
Household sector purchases goods and services
from production sector and they pay price for them.
Financial sector only plays the role of intermediaries
to convert savings of the household to investment.

Factor payments
Wages, Interest, Rent and Profit
Services of land Labor, Capital etc.

Saving

Household
Sector

Investment
Financial Sector

Production Sector

Goods and Services

Price of Goods and Services

Circular Flow of Income and Expenditure in Two Sector Economy

INCOME DETERMINATION IN TWO SECTOR ECONOMY:

Let, there are only two sectors in the economy,

household
sector
and
production
sector.
Household sector owns all the factors of
production and sell to production sector. On the
other hand, production sector hire factor services
from households and sell their entire product to
household sector. There is absence of tax and
subsidy from government sector. Export and
import of goods and services also absent in the
economy.there is no corporate savings or retained
earnings , total profit is distributed as dividends.

Under above stated conditions, the process of income

determination in two sector economy can be explained
as following:
According to the Keynesian model of income determination,
the equilibrium level of income is determined where ,
Aggergate demand=Aggregate supply
C+I=C+S
or,
I=S
As we know, Y=C+S, the economys equilibrium level of
income under two sector model is ,
Y=C+I
Given that, consumption function, C=a+bY and I is constant,
Y=a+bY+I
or, Y-bY=a+I
or,
Y(1-b)=a+I
or,
Y=(a+I)/(1-b)
1

( aof
income/output.
I)
or, which isYrequired
level

1 b

Determination of consumption:
As we know,

C a bY

1
a I
C a b

1 b
b

a I
C a

1 b

Which is required level of consumption at equilibrium

of two sector economy.

CIRCULAR FLOW OF INCOME AND EXPENDITURE

IN THREE SECTOR ECONOMY

Let there are three sectors in the economy

i.e. Household Sector, Production Sector
and Government Sector.
It is also the case of closed economy.
The Government Collects tax from both
household and production sector.
Govt.
provides
subsidy
and
Govt.
purchases to production sector and wages,
transfer payments to household sector.

Factor Payments
Factor Services

Wages salaries and

Transfer payments
Househol
d Sector

Government Purchases
and Subsidies
Productio
n Sector

Governme
nt Sector
Direct Income Tax

Direct and
Indirect Taxes

Goods and Services

Price of Goods and Services

Circular Flow of Income and Expenditure in Three Sector Economy

INCOME AND OUTPUT DETERMINATION IN THREE SECTOR

ECONOMY:

If the role of government is added to the two sector

economy, it is three sector economy. The government
influences economic activities through monetary
policy, fiscal policy, price policy, wage policy etc.
mathematically inclusion of government sector in
model introduces three variables; taxes (T),
government expenditure (G) and Transfer Payments
(GT). Assuming that, the government imposes only
direct taxes to the households, spends money on
buying factor services from household sector and
goods and services from production sector and also
makes
transfer payments
and subsidies to the
production sector.

Under the above stated conditions, the process of

income determination in three sector economy can
be explained algebrically as following:
MODEL I : Without Transfer Payments
Similarly as two sector model, the economy will be in
equilibrium when,
Aggregate demand = Aggregate
Supply

Given that, AD = C +I+G and AS = C+S+T

C+I+G = C+S+T
Again at equilibrium,
Y= C+I+G
in three sector model,
C= a+bYd
and, Yd= Y-T
T= Lump sum Tax

Hence, C=a+b(Y-T)
or, Y= a+b(Y-T)+I+G
or, Y-bY=a-bT+I+G
or, Y(1-b)= a-bT+I+G
Or,

1
a bT I G
Y
1 b

MODEL II-WITH TRANSFER PAYMENTS:

When transfer payments are included in the

model, consumption function can be written as,
C=a+b(Y-T+GT) where , GT= Transfer Payments
as we know,Y 1 a bT I G
1 b
Incorporating GT in above equation,
1
a b(T G T ) I G
Y
1 b

or,

1
a bT bG T I G
Y
1 b

Which is the equilibrium level of income in three

sector economy with Transfer payments.

FOUR SECTOR ECONOMY (OPEN ECONOMY)

CIRCULAR FLOW OF INCOME AND EXPENDITURE

IN FOUR SECTOR ECONOMY

Let there are four sectors in the economy i.e.

Household Sector, Production sector, Govt.
Sector and Foreign Sector.
It is the case of Open economy.
Economy receives from remittances and Exports.
Economy pays for foreign factors and Imports.
It needs following assumptions:
1. External sector consists only import and export
of goods and services.
2. Household sector exports only labor and capital.

Factor Payments
Factor Services

Wages salaries and

Transfer payments
Househol
d Sector

Government Purchases
and Subsidies
Productio
n Sector

Governme
nt Sector
Direct Income Tax

Direct and
Indirect Taxes

Goods and Services

Price of Goods and Services
Foreign Remittance and interest

Export of capital
and manpower

Foreign
Sector

Receipts from exports

Payments to Imports

Circular Flow of Income and Expenditure in Four Sector Economy

INCOME DETERMIANTION IN FOUR SECTOR MODEL:

Export as well as import function also

play vital role in determining income in
four sector economy.
Then, equilibrium level of income in four
sector economy can be written as,

Y C I G GT ( X M )

Given that,
C= a+b(Y-T+GT)
T T tY

GT GT

M M mY

Y a b(Y T GT ) I G X ( M mY )

Y a bY bT bGT I G X M mY
Y a bY b(T tY ) bGT I G X M mY
Y bY btY mY a bT bGT I G X M

1
Y
a bT bGT I G X M
1 b bt m

Which is equilibrium level of income and output of

complete four sector economy.

NUMERICAL ASSIGNMENTS:

a)
b)

Suppose in an two sector economy,

I=70, C= 60+0.8Yd, Yd=Y
Find the equilibrium Output.(Ans:650)
Find equilibrium output when there is
a 10$ increment in autonomous
investment. (Ans:700)

Given,
C=a+b(Y-T)
T=T+tY, where a=300, I=400, T=200
b=0.5, t=0.3, G=500
a) Determine the equilibrium levels of GDP,
consumption, saving.(1692.31, 792.31, 192.31)
b) What is the new equilibrium level of GDP
if government spending increases by 30?

(1738.46)

Consider a four sector economy with,

C=100+0.8(Y-T), I=1000, G=100
T=100, X=500 and M=0.25Y
Calculate the equilibrium level of
income of the economy. (1800)

a.

Given the consumption function,

C=a+b(Y-T), T=T +tY and the following
values
a=300, b=0.8, T =100, t=0.25
What is the value of tax revenue when Y=5000
(1350)

b.

c.

What is the level of disposable income when

Y=5000? (3650)
What is the level of consumption when Y=5000?
(3220)

Suppose a model is given as follows:

C=100+0.8Yd,
Yd=Y-T
I=150
G=50
T=20+0.25Y
Find,
a) equilibrium level of income, consumption and saving.
b) Change in equilibrium income if G increase to 100
and I decrease to 100.

THANK YOU!