Written by Harnisha Patil

June 7, 2021

There are two models of circular flow of income namely,

  1. Closed Economy Model
  2. Open-Economy Model

CLOSED ECONOMY is one in which there are no exports and imports. The economy is self-sufficient and self-reliant. In this economy, Gross Domestic Product is equal to Gross National Product.

Basically, Closed economy Model is a Three sector model

These three sectors considered here are

  1. Households
  2. Business firms
  3. Government  

In an economy household own the factor of production and provide the services of factors of production to business firms. The business firms produce goods and services and supply it to households. This is known as the REAL FLOW.

For factor services, households get payments which they use to buy goods and services from the firms. This is known as MONETARY FLOW.

Both, the households and firms pay taxes to the government and in return get reward for factor services. In this model, while savings and taxes are leakages, investment and subsidies represent injections into the circular flow.

The three-sector model can be explained with the help of the following diagram:         

The inner circle represents the real flow while the second circle see indicates the monetary flow. Savings of the households flow to the financial market and from there it flows to business firms as investments. The outer circle shows the payment of taxes to the government by the households and business firms and in return they get wages, transfer payments, subsidies etc. from the government. The economy will be in equilibrium when

Production = Consumption

Savings = Investments

Government’s Income = Government’s Expenditure




Y = Income

C = Consumption

I = Investment

G = Government

A more independent economy.Limited growth
Avoid exchange rate risks and global economic shocks.Fewer product variants
No pressure from imported productsExcluded from international relations

No doubt, close economy has its own advantages in today’s era but the world is converging to one, with the degree of globalization, reliance on resources, and technology it is highly impossible to have a closed economy and still keep on growing. On the other hand, a completely open economy is also highly volatile as its addiction on imports is high. It is advisable to build a mix of two economies such that the need is restrained and national players also get support from the government.


OPEN ECONOMY is one in which there are exports and imports. In other words, there is an existence of foreign trade. Along with the other flows in the closed economy model, there will be imports and exports from the households and business firms to the world economy and vice versa.

The following diagram represents the circular flow if income in an open economy.

Households and business firms export and import goods and services. For exports they get receipts and for import they have to make payments. If the exports are more than imports the flow of income will be more and if the imports are more than exports the flow of income will be less.

In this model, the leakages are savings, taxes and imports and the injections are the investments subsidies and exports. The economy will be in equilibrium when

Production = Consumption

Saving = Investment

Government’s Income = Government’s Expenditure

Exports = Imports

Receipts = Payments




C = Consumption

I = Investment

G = Government

NX = Net Exports – Net Imports

Economic growthRisk exposure
Lower costsIntensity of initial disturbance
Improved availability of goods and servicesImport dependence
Global prosperity and flow of productive resourcesGrowing bringing poverty

Difference between OPEN AND CLOSED ECONOMY

It doesn’t have an economic relation with the rest of the world.It has and economic relation with other countries.
Activities taking place outside the territory do not affect the economic activities.Economic activities of such an economy are affected by international fluctuations.
There is no difference between national income and domestic income.The size of national income may be greater or smaller than domestic income.
It is an imaginary economy.It is a realistic economy
It neither exports goods and services to foreign countries nor imports goods and services from foreign countries.It buys debentures, shares, bonds, etc. from foreign countries and sell debentures, shares, bonds, etc. to foreign countries
It doesn’t receive remittanceIt receives remittance

Here we had a look at both of the economy

India has a mixed economy

Thus each type has it’s own pros and cons. The United States is a very large and open economy—it imports and exports huge quantities of goods and services.

Over the past four decades, international trade and finance have become increasingly important.

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1 Comment

  1. Mayank Limkar

    Beautifull choice of topic 👍💯💯


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