In the circular flow model three sector economy, government intervention has also been accounted for, although it is still assumed to be a closed economy where the income flow is not influenced by any foreign sector. Besides the income and expenditure of the households and business firms, government purchases or expenditures and taxation also come into play. Here, government purchases are injections into the circular flow, while, taxation is a leakage.
Firstly, considering the flow of income and expenditure between household sector and the government, household sector pays income tax and commodity tax to the government. On the other hand, the government also makes transfer payments to the household sector in the form of various benefits and services like pension funds, relief, sickness benefits, health, education, and other services.
The flow of income and expenditure between the business sector and the government is similar. Business firms pay taxes to the government, the government, on the other hand, provides subsidies, makes transfer payments, and pays for the goods and services it purchases from the business sector.
As stated earlier, taxes paid by the household and the business sector are the leakages from the circular flow. This decreases not only the consumption and savings of the household sector but also investments and production of the business sector decrease.
However, the government offsets the leakages by buying services from the household sector, and goods and services from the business sector. This leads to an equilibrium in the circular flow as the level of demand meets the level of supply in the economy.
A part of the income earned by the government is saved and deposited in the capital market. The government also takes loans from the capital market either to meet the current expenditure or to invest in different projects.
The three sector model can be described in the following diagram:
If the government spends all its income received in the form of taxes, it flows back to the household and business sector in the form of subsidies and other government expenditures. This leads to the continuous circular flow of national income within the economy.