Circular Flow in Three Sector Model: A Model with Government Income and

Expenditure:
Assumptions:
1. The economy consists of household, business and government sector
2. There is government intervention
3. Government imposes tax and grants subsidy
4. There is perfectly competitive market
5. The economy has no international trade
6. Business and household sector pays taxes to the government

The three sector model:

 Model formed by adding the government sector to the two sector model
 Depicts a more realistic economy as it includes a government sector which plays an
important role in the economy.
 The economic role of government, refers to transferring household income to the
government through taxation and government expenditure which makes tax revenue flow
back to the households

(Government expenditure may take many forms including spending on capital goods and
services infrastructure (highway, power, communication) defense, and on education and
public goods.)
 Inclusion of government requires analyzing the effects of government fiscal
operations – taxation and expenditure
 Taxation is the withdrawal from the income flows to the household because they
reduce private disposal income and therefore on consumption expenditure and
savings.
 Government expenditure if the injection to the income stream- adds to aggregate
demand in form of government purchases of factor services from the household sector
and goods and services from the business firms
 The transfer payments (old age pensions, subsidies, unemployment allowances) by
the government are injections to the circular flow.
 They add to the household income that leads to household demand for consumer
goods.

(Transfer incomes are defines ad money flow without reverse flow of goods and
services)
 The real flow from and to the government has been excluded to avoid confusion and
overcrowding
 Each money flow has a reverse flow expect transfer payments
 As the figure shows a part of household income is taken away by the government in
the form of taxes
 A part of business income is taken away by the
government in the form of corporate taxes
 The indirect taxes taken away from the household by
business firms are transferred to the government
 The government spends a part of his tax revenue on
wages salaries and transfer payments to the households
and a part on its purchases from the firms and payment
of subsidies.
 Thus the money that flows from household and firs to
the government in form of taxes flows back to the
sectors on form of government expenditure.
Injections and withdrawals
 Total revenue is assumed to be equal to total government spending
 In reality two variables may not ne necessarily equal
 It depends on the government budgetary policy, if government adopts balanced budget
policy then G=T
 If deficit G>T (Injection in the economy)
 If surplus G<T (withdrawals)
 Deficit budget means injections to the circular flow as it expands the circular flows
whereas surplus budget is net withdrawals and reduces the volume of circular flow.

National Income Accounting in three sector economy

 In the three sector model the inclusion of government affects the overall economic
situation
 Value of output produced in the economy which equals to the factor payments is the
income of the households sector.
 A part of the income is taken away by the government s in the form of taxes (direct and
indirect).
 So the total income in the three sector economy can be illustrated as

Y = C+I+T
Where Y = Income
C = Consumption Expenditure
I = Investment Expenditure
T = Taxes

 The government makes the tax revenue flow back to the household in the form of
government expenditure including transfer payments
 The total expenditure flow in the economy is the sum of consumption expenditure,
Investment expenditure and government expenditure.
So the national income in the four sector economy becomes
(NI) Y = C+I+G
1. In which situation government Expenditure equals Taxes?
2. Which type of Expenditure do not have opposite flow?
3. Does the balanced budget of the government affect the circular flow of income?
How?
4. What are the injections and withdrawals in the three sector model?
5. How is national income determined in three sector model?