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National Income Determination: (Three Sector Model)

- In a three sector economy model, the government sector is added to the traditional two sector model of consumption (C) and investment (I). - The key variables included due to the government sector are government expenditures (G) and taxes (T). - In the three sector model, aggregate demand (AD) equals consumption (C) plus investment (I) plus government expenditures (G). - An increase in government spending has a multiplier effect on national income, greater than the initial increase in G, due to subsequent rounds of spending. The government expenditure multiplier (KG) measures the ratio of the change in income to the change in government spending.

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Yash Kumar
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450 views12 pages

National Income Determination: (Three Sector Model)

- In a three sector economy model, the government sector is added to the traditional two sector model of consumption (C) and investment (I). - The key variables included due to the government sector are government expenditures (G) and taxes (T). - In the three sector model, aggregate demand (AD) equals consumption (C) plus investment (I) plus government expenditures (G). - An increase in government spending has a multiplier effect on national income, greater than the initial increase in G, due to subsequent rounds of spending. The government expenditure multiplier (KG) measures the ratio of the change in income to the change in government spending.

Uploaded by

Yash Kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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National Income

Determination
(Three Sector Model)
Three Sector Model

 A Three Sector Model of income determination consists of two sector model


and Government sector. Inclusion of the Government into the model brings in
two variables :
--Government Expenditures (G)
--Taxes (T)
To make our analysis a realistic one, we assume the existence of the government
sector that has the power to spend and collect taxes. In a two-sector economy,
AD= C + I.
But in a three-sector economy, without any trading relationship with the outside
world, AD = C + I + G.
 Thus, government spending is an important element of aggregate demand or
expenditure.
Similarly, imposition of taxes by the government results in a change in
disposable income.
Disposable income, also known as disposable personal income (DPI), is the
amount of money that households have available for spending and saving
after income taxes have been accounted for.
Inclusion of Govt expenditures and taxes

 Assumption:
Government allows a balanced budget ,i.e.,
Government Expenditure(G) = Government Revenue(Taxes)
Therefore, G=T
AS=AD
AS=C+S+T
AD=C+I+G
C+S+T=C+I+G
Y=C+I+G
 Disposable income:
Y-T=Y(d)
C=a + bY(d)
Y=C+I+G
Y=a + bY(d)+I+G
Y=a+ bY- bT+ I+ G
Y- bY=a- bT+ I+ G
Y(1-b)=a-bT + I +G
Y=1/(1-b)[a-bT + I +G]
Government Expenditure Multiplier: G-
Multiplier

 Like private investment, an increase in government spending results in an


increase in national income.
Thus, its effect on national income is expansionary. There is a limit to private
investment. Thus, to stimulate income the gap has to be filled up by government
expenditure.
However, the increase in income is greater than the increase in government
spending. The impact of a change in income following a change in government
spending is called government expenditure multiplier, symbolised by kG.
 The government expenditure multiplier is, thus, the ratio of change in income
(∆Y) to a change in government spending (∆G). Thus,
 KG = ∆Y/∆G and ∆Y = KG. ∆G
 In other words, an autonomous increase in government spending generates a
multiple expansion of income. How much income would expand depends on the
value of MPC or its reciprocal, MPS. The formula for KG is the same as the simple
investment multiplier, represented by m.
 Its formula (i.e., KG) is:
 KG = ΔY = 1
ΔG 1–b
 Investment Multiplier, m = ΔY = 1
ΔI 1–b
Where b is the marginal propensity to consume,
Question:

 In a two sector economy, the basic equations are as follows:


The Consumption function is C = 200 + 0.8Yd and investment is I = 300 millions.
The equilibrium level of income is 2500 millions. Presume the government is
added to this two sector model, which then becomes a three sector economy.
The government expenditure is at 100 millions
a) Determine the equilibrium level of income in the three sector economy
b) What is the multiplier affect of the government expenditure? Is it of the same
magnitude as the multiplier effect of a change in the autonomous investment?
c) Presume that there is a balanced budget in that the entire government
expenditure is financed from a lump sum tax. Find the new equilibrium level of
income in the three sector economy.
 Solution
a) The equilibrium condition in the three sector economy is given as
Y = C+I+G
Thus,
Y = 200 + 0.8Y + 300 + 100
Y = 600 + 0.8Y
Y – 0.8Y = 600
0.2Y = 600
Y = 600 / 0.2
The equilibrium level of income in the three sector economy is 3,000
millions, which is an increase by 500 millions over the two sector economy
b) Government Expenditure Multiplier
GM = ΔY = 1
ΔG 1–b
= 1 / 1 – 0.80
= 5
Investment Multiplier, m = ΔY = 1
ΔI 1–b
 Where b is the marginal propensity to consume,
 c) G = T = 100 million
Thus ,
C = 200 + 0.8 (Y -100)
C = 200 – 80 + 0.8Y
C = 120 + 0.8Y
But , Y = C+I+G
Y = 120 + 0.8Y + 300 + 100
Y – 0.8Y = 120 + 400
0.2Y = 520
Y = 520 / 0.2
The new equilibrium level of income in the three sector economy, when there
exists a balanced budget is 2,600 millions.
Question:

 Given: C=100+.075Y
I=100
G=T=50
Find Y.

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