Circular Flow in a two-sector economy without the financial market assumed that there are no savings, Le, households spend their entire income on purchase of goods and services and firms spend all the receipts from sale of goods and services in making factor payments.
But, in actual practice, households do not spend their entire income on consumption, i.e., a part of their income is saved Similarly, firms also save some part of their receipts for expansion or other reasons. Firms also borrow money to finance their expansion programmes. All savings and borrowings are channelised through a financial market, Financial market refers to institutions such as banks, insurance companies etc., which transact in loanable funds. Savings of households accumulated in the financial market are utilised by firms for investment purposes. So, the circular flow of income continues as shown in the following diagram:

Circular flow of income in a three-sector economy, consists of households, firms and the government sector. Government plays a very important role in the economic development of a country. It acts as both consumer and a firm. As a consumer, it spends on consumption of goods and services produced by firms. As a producer, it produces goods and services for the economy. In addition to flows of circular flow in two-sector economy with financial market, the introduction of Government leads to following flows:

• Between Households and Government: Money flows from government to households in the form of: (i) Transfer payments like scholarships, old age pension, etc.; and (ii) Factor payments for hiring factor services of households.
Money flows back to the government from households in the form of direct taxes like income tax, interest fax, etc.

• Between Firms and Government: Money flows from firms in the form of direct taxes indirect taxes.
Money flows to the firms from government, when the latter grants subsidies and males payment to the former for purchase of goods and services produced by the firms.

A part of the income earned by government is also saved and deposited in the finansa market. Government also borrows money from the financial market to meet its expenditure A brief summary of this circular flow is given in the following diagram:

Government Sector performs the following activities in the economy:

(a) Government collects taxes from households and firms.

(b) Government makes transfer payments to the households and provides subsidies to the firms.

(c) Government makes the payment for purchase of goods and services from the firms.

(d) Government saves and borrows money with the help of financial market.

Circular flow of income in a four-sector economy consists of households, firms, government and foreign sector. The various money flows in each sector are:

• Household Sector: Households provide factor services to firms, government and foreign sector. In return, it receives factor payments. Households also receive transfer payments from the government and the foreign sector. Households spend their income on: (i) Payment for goods and services purchased from firms; (ii) Tax payments to government; (iii) Payments for imports.

• Firms: Firms receive revenue from households, government and the foreign sector for sale of their goods and services. Firms also receive subsidies from the government. Firm makes payments for: (1) Factor services to households; (ii) Taxes to the government; (iii) Imports to the foreign sector.

•Government: Government receives revenue from firms, households and the foreign sector for sale of goods and services, taxes, fees, etc. Government makes factor payments to households and also spends money on transfer payments and subsidies.

• Foreign Sector: Foreign sector receives revenue from firms, households and government for export of goods and services. It makes payments for import of goods and services from firms and the government. It also makes payment for the factor services to the households.

The savings of households, firms and the government sector get accumulated in the financial market. Financial market invests money by lending out money to households, firms and the government. The inflows of money in the financial market are equal to outflows of money. It makes the circular flow of income complete and continuous. The circular flow of income in a four-sector economy is shown in below image