July 17, 2024 

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DISCRETIONARY MONETARY POLICY: Explicit changes in the money supply and/or interest rates (monetary policy) that are made with the expressed goal of stabilizing business cycles, reducing unemployment, and/or lowering inflation. Discretionary fiscal policy is a similar type of policy.

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A circular flow model of the macroeconomy containing three sectors (business, household, and government) and three markets (product, factor, and financial) that illustrates the continuous movement of the payments for goods and services between producers and consumers, with particular emphasis on taxes and government purchases. Other circular models are two-sector, two-market circular flow; two-sector, three-market circular flow; and four-sector, three-market circular flow.
The three-sector, three-market circular flow model highlights the key role that the government sector plays in the macroeconomy. It expands the circular flow model by illustrating how taxes are diverted from consumption expenditures to the government sector and then used for government purchases. It illustrates that taxes do not vanish from the economy, but are merely diverted.

Three Sectors, Three Markets

The three macroeconomic sectors included in this model are:
  • Household Sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.
  • Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.
  • Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. It buys a portion of gross domestic product as government purchases.
The three macroeconomic markets in this version of the circular flow are:
  • Product markets: This is the combination of all markets in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market.
  • Resource markets: This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.
  • Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

Spotlight on the Government Sector

The three-sector, three-market circular flow model highlights the role played by the government sector. The government sector buys a portion of gross domestic product flowing through the product markets to pursue its assorted tasks and functions, such as national defense, education, and judicial system. These expenditures are primarily financed from taxes collected from the household sector. However, when tax revenue falls short of expenditures, the government sector is also prone to borrow through the financial markets.

The government sector, as such, adds three key flows to the model--taxes, government purchases, and government borrowing. These flows divert, but do not destroy, a portion of the core flow of production, income, and consumption.

Taxing and Spending and Borrowing

Adding Government
Circular Flow

This diagram presents the three-sector, three-market circular flow. At the far left is the household sector, which contains people seeking consumption. At the far right is the business sector that does the production. At the top is the product markets that exchange final goods and services. At the bottom is the resource markets that exchange the services of the scarce resources. Just above the resource markets are the financial markets that divert saving to investment expenditures. In the very center is the government sector.
  • Taxes: With the government sector in place, the next step in the construction of the three-sector, three-market circular flow is taxes. Taxes are household sector income that is diverted to the government sector. The household sector is forced to divert part of income away from consumption and saving because the government sector mandates that they must. Click the [Taxes] button to reveal the flow of taxes from the household sector to the government sector.

  • Government Purchases: The primary reason that the government sector collects taxes from the household sector is to pay for government purchases. Government purchases by the government sector then become the third basic expenditure on gross domestic product that flows through the product markets. Click the [Purchases] button to highlight this flow from the business sector to the product markets.

  • Government Borrowing: Taxes are not the only source of income used to finance government purchases (which often happens). When taxes fall short of government purchases, the difference is made up with government borrowing. The government sector, like the business sector, often sells legal claims as a means of borrowing the income that can used for government purchases. Click the [Borrowing] button to highlight this flow from the financial markets to the government sector.
Combining all three flows indicates the key role played by the government sector. Taxes flow from the household sector to the government sector. This flow then heads to the product markets as government purchases where it is supplemented with borrowing from financial markets. Click the [Complete Model] button to illustrate.

Income diverted away from consumption expenditures by the household sector as taxes finds its way back to the product markets as government purchases by the government sector.

The key to the addition of the government sector to the circular flow is that taxes do NOT disappear as they move from sector to sector, they are merely diverted. In other words, taxes do not remain in the government sector, but merely pass through on the way to the product markets.

What It All Means

What happens when the government sector is included in the circular flow model?

  • First, the government diverts a portion of the circular flow. But this diversion that does not necessarily change the total amount of gross domestic product, factor payments, or national income. It merely diverts income from consumption and saving to taxes. And it diverts gross domestic product from consumption and investment to government purchases.

  • Second, the total flow of government purchases is as important, if not more so, than the source of financing. If the government sector spends a trillion on government purchases, this must be paid for with national income, either through taxes or saving. If borrowing declines and purchases remain unchanged, then taxes must rise. If taxes decline and purchases remain unchanged, then borrowing must rise.

  • Third, although the total flow is unchanged, shifting income between taxes, consumption, and saving can and does affect the economy. If the tax flow increases, then less remains for consumption and saving. Either the household sector satisfies fewer wants and needs or the business sector borrows less to invest in growth-promoting capital goods. Diverting income to government purchases and away from investment is termed the crowding-out effect, and worries people concerned about big government.

  • Fourth, while the size of government is important, so too are specific government purchases. Government spending can be wasteful and unneeded, or it can provide valued goods, including national defense, education, transportation systems, police and fire protection, the judicial system, and environmental quality. In some cases, household consumption and business investment are more valuable than government purchases. In other cases, government purchases are more valuable.

Other Models

This three-sector, three-market circular flow is one of four alternative circular flow models, each containing a different number of sectors or markets. The other three models are:
  • Two Sectors, Two Markets: The simplest circular flow model contains two sectors (household and business) and two markets (product and resource). This model highlights the core circular flow of production, income, and consumption.

  • Two Sectors, Three Markets: A second version of the circular flow model adds the financial markets to the basic model. This addition illustrates how saving is diverted from the household sector to the business sector to finance investment expenditures.

  • Four Sectors, Three Markets: The most comprehensive circular flow model includes the foreign sector. Adding the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.


Recommended Citation:

THREE-SECTOR, THREE-MARKET CIRCULAR FLOW, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2024. [Accessed: July 17, 2024].

Check Out These Related Terms...

     | physical flow | payment flow | circular flow | two-sector, two-market circular flow | two-sector, three-market circular flow | four-sector, three-market circular flow |

Or For A Little Background...

     | taxes | government purchases | macroeconomic markets | product markets | resource markets | financial markets | macroeconomic sectors | household sector | business sector | government sector | production | consumption | model | market | exchange | economy |

And For Further Study...

     | business cycles | macroeconomic goals | macroeconomic problems | macroeconomic theories | government functions | unemployment | inflation |

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