National Income Determination in Three Sector Economy

1. In the two sector economy there is only the household and private sector
2. However, in the real world there is also the government sector which makes
spending and taxation decisions
3. There is much controversy over the appropriate role government should play in the
economy. This controversy constantly shifts between positive and normative
arguments.
4. Keynesians believe that the macroeconomy is likely to fluctuate too much if left on
its own
5. On the other hand, Classicals claim that fiscal and monetary policies are incapable
of stabilizing the economy
6. However, today it is widely accepted that government has an important role to play
 National Income Determination in Three Sector Economy

1. Government undertakes spending through two way: consumption expenditure on

goods and services and secondly through transfer payments
2. The spending on goods and services become a part of aggregate spending;
therefore government spending raises aggregate spending
3. Transfer payments refer to payments in the form of pension, scholarships,
unemployment benefits etc. in return of which no goods and services are provided
to the government
4. To make these purchases and transfer payments, the government needs revenue
which it raises through taxes.
5. Now, transfer payments and taxes have an impact on the income level available
with the individuals for expenditure. Because taxes reduce; the disposable income
or after-tax income changes
 National Income Determination in Three Sector Economy

1. For finding the level of disposable income, we use net taxes

2. Net taxes (T) refer to taxes minus the transfer payments received by the
households.
3. We deduct transfer payment from taxes because the government drains tax revenue
from the household sector.
4. Some of this tax revenue is returned to households in the form of transfer payments
(welfare, social security, unemployment insurance, etc.).
5. These transfer payments are funds taken from one household and given to another.

6. The disposable income = Yd =Y-T

Planned aggregate expenditure now includes government purchases of

goods and services (G): AE ≡ C + I + G.
 National Income Determination in Three Sector Economy

1. The circular flow of income looks like:

 National Income Determination in Three Sector Economy

1. Consumption spending now depends on disposable personal income rather than on

personal (before-tax) income: C = a + bYd so C = a + b(Y − T).

2. For finding the equilibrium in the three sector economy we still find the level of
income that makes actual output equal to the aggregate expenditure/spending in the
economy:

3. The equilibrium analysis in the two sector model applies here also. If output (Y) exceeds
planned aggregate expenditure (C + I + G), there will be an unplanned increase in inventories
4. Conversely, if C + I + G exceeds Y, there will be an unplanned decrease in inventories.
 National Income Determination in Three Sector Economy

1. We next move on to finding the government spending multiplier,

 National Income Determination in Three Sector Economy

1. Graphically the equilibrium is depicted as follows,

2. Here, the aggregate expenditure cure shifts upward by amount equal to I+G
 National Income Determination in Three Sector Economy

1. Let us take a numerical example of how the equilibrium level of income is found,
2. C = 100 + .75Yd
3. Now, we can write, the Yd = Y-T, therefore C= 100+0.75(Y-t)
4. Example:
5.