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Show the circular flow of income in a two-sector model with leakages and injections.

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An Economy can be classified in various ways. One such way is purely theoretical. In this context, there are four sectors of an economy. These are households, firms, government and the rest-of-the-world. If we consider only the first three sectors, it becomes a closed economy. Inclusion of the last sector (also called the foreign sector) makes it an open economy. Considering only the first two sectors, it becomes a two-sector model;

Circular flow of income model is a model used to show the flow of income through an economy. Through showing the leakages in the economy and the injections, the different factors affecting the economic activities are apparent. Just like leakage in a fish tank, a leakage in the economy. leads to a decrease in economic activity.

And just like an injection into a fish tank where the water level rises, an injection in an economy leads to an increase in economic activity. To understand how the circular flow of income can be used to show disequilibrium in the economy you must first understand what disequilibrium is. Disequilibrium is the state where economic activity is not equal, that is where leakage > injections or when leakages < injections. whereas the state of equilibrium is when leakages = injections. Hence disequilibrium is when the savings are either greater or less than the investment.

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