Two Sectors, Three Markets

• 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.

• 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 Financial Markets

Financial markets, as such, enable the addition of three key flows to the model--saving, investment expenditures, and investment borrowing. These flows divert, but do not destroy, a portion of the core flow of production, income, and consumption to the business sector.

Diverted Saving

Trading Legal Claims

• Saving: With financial markets in place, the next step in the construction of the two-sector, three-market circular flow is saving. Saving is household sector income that is not used for consumption expenditures but rather is diverted to the financial markets. The household sector is on the buying side of financial markets. It diverts income when it buys legal claims. Click the [Saving] button to reveal this flow of saving from the household sector to the financial markets.


• Investment Borrowing: Household saving does not stop when it reaches the financial markets. Financial markets are a conduit that diverts the flow of saving to the business sector. The business sector is on the borrowing side of the financial markets. By selling legal claims it borrows the income that can used for investment expenditures. Click the [Borrowing] button to highlight this flow from the financial markets to the business sector.


• Investment Expenditures: The primary reason that the business sector borrows income through the financial markets is for investment expenditures on capital goods. Investment expenditures by the business sector then becomes the second basic expenditure on gross domestic product that flows through the product markets. Click the "Expenditures" button to highlight this flow from the business sector to the product markets.

Income diverted away from consumption expenditures by the household sector finds its way back to the product markets as investment expenditures by the business sector.

What It All Means

Summing up, consider three points:

• First, including saving, investment, and financial markets in the circular flow model does not change the total volume of the circular flow. Gross domestic product, factor payments, and national income remain unchanged. Financial markets merely divert part of the flow away from consumption and to investment. It is the same basic diversion discussed in analysis of investment in the production possibilities model.


• Second, in this model, saving diverted into financial markets is, in general, equal to the investment borrowing coming out, and thus investment expenditures by the business sector. In practice, however, there are periods in which saving is less than investment or investment is less than saving. These periods are not just curiosities, but are fundamental to the economy. Imbalances between saving and investment often trigger economic instability--business cycles, unemployment, and inflation--that underlies much of the study of macroeconomics.


• Third, there is more to the financial markets that just business sector borrowing. In particular, the government sector is a frequent financial market borrower, as well. The government sector also issues legal claims through the financial markets as a means borrowing.

Other Models

• 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.


• Three Sectors, Three Markets: Another version of the model includes the government sector. This model highlights the importance of taxes, which are also diverted from household sector income and used to finance government purchases.


• 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.