1. The Two-sector Model of the Economy (Households and Firms)
The households (consumers):
Require goods and services to satisfy their personal wants
Own all resources (i.e. labour, capital, land, enterprise)
Sell resources to businesses
Gain income (e.g. wage, interest, rent, profit) from such sales
The firms/business sector (producers):
Uses resources provided by households to produce goods and services
Sells those goods and services for income

2. The Two-sector Model of the Economy
Assumptions:
Businesses are the only producers
All goods and services are sold to consumers
Consumers spend ALL their income on goods and services
There are no resource inventories
Therefore:
Total demand (expenditure) = total supply (output)
The economy will always be in equilibrium
(cont.)

3. The Two-sector Model of the Economy (cont.)
Two groups of decision makers
Households (sell their resources)
Firms (sell goods and services)
Interaction between the two sectors through markets:
Resource (factor) markets
Product markets
(cont.)

4. The Two-sector Model of the Economy (cont.)
Productive resources
Factor market
Income
Household sector
Firms sector
Goods and Services
Product market
Expenditure

5. In the Basic Circular Flow
O = Y = E
Where:
O = output (production)
Y = income
E = expenditure (demand)

6. The Financial Sector
Saving (S) = Part of the Income that is not spent (leakage)
Total income = consumption spending + saving, i.e. Y = C + S
Investment (I) = that part of production that is not used for current consumption, e.g. capital goods
Total income (Y) = C + I
Investment is an injection. If:
S > I, the economy contracts
S < I, the economy expands
S = I, the economy is in equilibrium
The financial sector acts as an intermediary between lenders and borrowers

7. The Government Sector
Government taxation (T) reduces households’ disposable income and business funds
Taxation (T) is a leakage (outflow)
Government spending (G) includes expenditure on collective goods and services and goods and services provided by the business sector, plus transfer payments (social security payments)

8. The Modified Five-sector Model of the Economy
It is a five-sector model of the economy:
The household sector
The firms sector
The government sector
The financial sector
The external (overseas) sector

9. The Two-sector Model of the Economy (cont.)
Household sector
Financial
sector
Government
External
Firms
Imports
Savings
Government expenditure
Exports
Taxation
Investment
INJECTIONS
LEAKAGES
Expenditure
Income

10. The Open Economy Total leakages (outflows) are S, T and M
Total injections are I, G and X
The impact of total leakages/injections on the economic activity is as follows:
S + T + M = I + G + X equilibrium
S + T + M > I + G + X contraction
S + T + M < I + G + X expansion