Lecture 5 - National Income Determination in a Three Sector Economy | Macroeconomics- Learning and Analysis PDF Download

 Page 1


National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subject: Macroeconomics 
Lesson: National Income Determination in a 
Three Sector Economy 
Lesson Developer : Rajeev Kumar 
College/Department : SRCC, University of Delhi 
  
Page 2


National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subject: Macroeconomics 
Lesson: National Income Determination in a 
Three Sector Economy 
Lesson Developer : Rajeev Kumar 
College/Department : SRCC, University of Delhi 
  
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
Table of Contents 
 Chapter : National Income Determination in a Three Sector 
Economy 
? 1: Learning Outcomes 
? 2: Introduction 
? 3: First Title 
? 3.1: First Sub-Title 
? 3.2: Second Sub-Title 
? 4: Second Title 
? 4.1: First sub-title 
? 4.2: second sub title 
? Summary  
? Exercises 
? Glossary 
? References 
? Quiz 
 
1. Learning Outcomes 
 
After you have read this chapter, you should be able to  
? Define: Desired Consumption Expenditure, Desired Investment Expenditure, 
Aggregate Expenditure and Aggregate Supply 
? Understand: Aggregate Demand, Aggregate Supply, Components of 
Aggregate Expenditure,  Equilibrium of GDP and Circular Flow of Income in 
three sector economy   
? Identify: The three sector economy, Types of expenditures in three sector 
economy and equilibrium condition   
? Differentiate between two sector and three sector economy, private 
expenditure and public expenditure, investment expenditure and consumption 
expenditure and ex ante and ex post expenditure 
? Appreciate relevance of the determination of income 
? Apply the knowledge of national income determination in three sector 
economy to your other macroeconomic studies and extend the three sector 
model to four sector model by incorporating into it the external sector.  
 
 
2. Introduction 
 
A three sector economy is a closed economy. It has no trade relations with the rest 
of the world. This means that the country does not export or import anything.  In 
this model a private sector and a public sector (government sector) coexist. The 
government and the private sector both invest and consume. The public sector 
regulates the private sector according to the needs of the economy. The public sector 
tries to achieve various objectives like economic growth, macroeconomic stability 
and equitable distribution of income through fiscal policy. 
 
3: Assumptions of the Three Sector Economy Model 
 
Important Assumptions of the Model: The three sector economy model relies upon 
the following key assumptions. : 
Page 3


National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subject: Macroeconomics 
Lesson: National Income Determination in a 
Three Sector Economy 
Lesson Developer : Rajeev Kumar 
College/Department : SRCC, University of Delhi 
  
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
Table of Contents 
 Chapter : National Income Determination in a Three Sector 
Economy 
? 1: Learning Outcomes 
? 2: Introduction 
? 3: First Title 
? 3.1: First Sub-Title 
? 3.2: Second Sub-Title 
? 4: Second Title 
? 4.1: First sub-title 
? 4.2: second sub title 
? Summary  
? Exercises 
? Glossary 
? References 
? Quiz 
 
1. Learning Outcomes 
 
After you have read this chapter, you should be able to  
? Define: Desired Consumption Expenditure, Desired Investment Expenditure, 
Aggregate Expenditure and Aggregate Supply 
? Understand: Aggregate Demand, Aggregate Supply, Components of 
Aggregate Expenditure,  Equilibrium of GDP and Circular Flow of Income in 
three sector economy   
? Identify: The three sector economy, Types of expenditures in three sector 
economy and equilibrium condition   
? Differentiate between two sector and three sector economy, private 
expenditure and public expenditure, investment expenditure and consumption 
expenditure and ex ante and ex post expenditure 
? Appreciate relevance of the determination of income 
? Apply the knowledge of national income determination in three sector 
economy to your other macroeconomic studies and extend the three sector 
model to four sector model by incorporating into it the external sector.  
 
 
2. Introduction 
 
A three sector economy is a closed economy. It has no trade relations with the rest 
of the world. This means that the country does not export or import anything.  In 
this model a private sector and a public sector (government sector) coexist. The 
government and the private sector both invest and consume. The public sector 
regulates the private sector according to the needs of the economy. The public sector 
tries to achieve various objectives like economic growth, macroeconomic stability 
and equitable distribution of income through fiscal policy. 
 
3: Assumptions of the Three Sector Economy Model 
 
Important Assumptions of the Model: The three sector economy model relies upon 
the following key assumptions. : 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
o National Income, national Output, Aggregate Supply and GDP are all treated 
as equivalently. In a closed economy the difference between Gross Domestic 
Product (GDP) and Gross National Income (GNI) is merely the depreciation. 
o The economy is a closed economy having no trade relations with any other 
countries.  
o It is a capitalist and free market economy. It means that individuals are the 
owners of productive resources (land, labour and capital) directly or 
indirectly. 
o There exists a government sector but it does not participate in production 
process. It purchases the output of the private sector. However in reality 
government also produces various goods and services such as health and 
education.  
o It is a short run analysis. The short run helps in analyzing the short run 
deviation of actual GDP from potential GDP or the ‘GDP gap’. It also explores 
how to minimize the magnitude of the negative and positive GDP gaps. 
o It is a constant price model that is price level does not change. 
o It is also assumed that there exists an excess productive capacity in the 
economy. It means the economy can produce more when aggregate demand 
increases without putting an upward pressure upon price level. It also implies 
that every change in GDP will be only in real GDP.  
o It assumed for the sake of simplicity that there is no induced investment 
expenditure.  All Investment expenditures are autonomous that is it does not 
change in response to change in the national income.  
3.1: Classification of the three sectors: 
 
In three sector economy consumption expenditure, Investment expenditure and 
Government expenditure are considered as the three different sectors for the 
purpose of analysis. 
In such an economy government imposes taxes (T) upon the private sector. The 
after tax income or disposable income of the private sector is the difference between 
the GDP or national income and the Taxes paid. 
Y
d
 = Y - T 
Where Yd is the disposable income, Y is the national income and T is the taxes 
collected by the government. 
 
According to the Keynesian psychological law of consumption households consume a 
part of their disposable incomes and save the remaining. So consumption and 
savings are the only two components of disposable national income. 
 
So  
          Y
d
 = Y – T = C + S …………………………(1) 
Where, C and S stand for private consumption expenditure and saving respectively. 
Alternatively by rearranging the equation (1) we get an identity 
           Y = C + S + T …………..……………………(2) 
 
3.1 Supply Side View of A Three Sector Economy  
 
The identity at (2) above also shows the supply side of the economy. It shows flow 
of goods and services in the economy during a period of time. Alternatively it is 
Page 4


National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subject: Macroeconomics 
Lesson: National Income Determination in a 
Three Sector Economy 
Lesson Developer : Rajeev Kumar 
College/Department : SRCC, University of Delhi 
  
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
Table of Contents 
 Chapter : National Income Determination in a Three Sector 
Economy 
? 1: Learning Outcomes 
? 2: Introduction 
? 3: First Title 
? 3.1: First Sub-Title 
? 3.2: Second Sub-Title 
? 4: Second Title 
? 4.1: First sub-title 
? 4.2: second sub title 
? Summary  
? Exercises 
? Glossary 
? References 
? Quiz 
 
1. Learning Outcomes 
 
After you have read this chapter, you should be able to  
? Define: Desired Consumption Expenditure, Desired Investment Expenditure, 
Aggregate Expenditure and Aggregate Supply 
? Understand: Aggregate Demand, Aggregate Supply, Components of 
Aggregate Expenditure,  Equilibrium of GDP and Circular Flow of Income in 
three sector economy   
? Identify: The three sector economy, Types of expenditures in three sector 
economy and equilibrium condition   
? Differentiate between two sector and three sector economy, private 
expenditure and public expenditure, investment expenditure and consumption 
expenditure and ex ante and ex post expenditure 
? Appreciate relevance of the determination of income 
? Apply the knowledge of national income determination in three sector 
economy to your other macroeconomic studies and extend the three sector 
model to four sector model by incorporating into it the external sector.  
 
 
2. Introduction 
 
A three sector economy is a closed economy. It has no trade relations with the rest 
of the world. This means that the country does not export or import anything.  In 
this model a private sector and a public sector (government sector) coexist. The 
government and the private sector both invest and consume. The public sector 
regulates the private sector according to the needs of the economy. The public sector 
tries to achieve various objectives like economic growth, macroeconomic stability 
and equitable distribution of income through fiscal policy. 
 
3: Assumptions of the Three Sector Economy Model 
 
Important Assumptions of the Model: The three sector economy model relies upon 
the following key assumptions. : 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
o National Income, national Output, Aggregate Supply and GDP are all treated 
as equivalently. In a closed economy the difference between Gross Domestic 
Product (GDP) and Gross National Income (GNI) is merely the depreciation. 
o The economy is a closed economy having no trade relations with any other 
countries.  
o It is a capitalist and free market economy. It means that individuals are the 
owners of productive resources (land, labour and capital) directly or 
indirectly. 
o There exists a government sector but it does not participate in production 
process. It purchases the output of the private sector. However in reality 
government also produces various goods and services such as health and 
education.  
o It is a short run analysis. The short run helps in analyzing the short run 
deviation of actual GDP from potential GDP or the ‘GDP gap’. It also explores 
how to minimize the magnitude of the negative and positive GDP gaps. 
o It is a constant price model that is price level does not change. 
o It is also assumed that there exists an excess productive capacity in the 
economy. It means the economy can produce more when aggregate demand 
increases without putting an upward pressure upon price level. It also implies 
that every change in GDP will be only in real GDP.  
o It assumed for the sake of simplicity that there is no induced investment 
expenditure.  All Investment expenditures are autonomous that is it does not 
change in response to change in the national income.  
3.1: Classification of the three sectors: 
 
In three sector economy consumption expenditure, Investment expenditure and 
Government expenditure are considered as the three different sectors for the 
purpose of analysis. 
In such an economy government imposes taxes (T) upon the private sector. The 
after tax income or disposable income of the private sector is the difference between 
the GDP or national income and the Taxes paid. 
Y
d
 = Y - T 
Where Yd is the disposable income, Y is the national income and T is the taxes 
collected by the government. 
 
According to the Keynesian psychological law of consumption households consume a 
part of their disposable incomes and save the remaining. So consumption and 
savings are the only two components of disposable national income. 
 
So  
          Y
d
 = Y – T = C + S …………………………(1) 
Where, C and S stand for private consumption expenditure and saving respectively. 
Alternatively by rearranging the equation (1) we get an identity 
           Y = C + S + T …………..……………………(2) 
 
3.1 Supply Side View of A Three Sector Economy  
 
The identity at (2) above also shows the supply side of the economy. It shows flow 
of goods and services in the economy during a period of time. Alternatively it is 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
nothing but the gross domestic product that is the sum of the value of the final 
goods and services produced during a year. In the closed economy only this sum is 
available for the purpose of consumption and investment by the private and the 
public sector both. If government takes away large part of it by charging higher 
taxes less will be left for the private sector’s use.    
 
 
3.2 Expenditure side or demand side view of the three sector economy: 
  
In a three sector economy, aggregate expenditure or aggregate demand is the sum 
of Consumption Expenditure and Investment expenditure of private and government 
sector. 
Alternatively,  
Aggregate Expenditure in a three sector economy = Expenditure in Private Sector + 
Expenditure in government Sector 
However Expenditure in Private Sector has two components: 
i) Private Consumption Expenditure 
ii) Private Investment Expenditure 
Similarly Expenditure in Public Sector has two components: 
i) Government Consumption Expenditure 
ii) Government Investment Expenditure 
Private Consumption Expenditure: Private consumption expenditure is the 
expenditure incurred by the individuals and households on the goods and services for 
final consumption. 
Private Investment Expenditure: The private investment expenditure is that 
expenditure which is incurred by the private sector on creating physical assets like 
tools, machinery, equipments and building.  
Government Consumption Expenditure: Government consumption expenditure is 
that part of the overall expenditure which is incurred in various departments and 
ministries of the government on the goods and services for final consumption. 
Government Investment Expenditure: Government investment expenditure is 
that expenditure which is incurred by various departments and ministries of the 
government on creating physical assets like tools, machinery, equipments and 
building. 
 
 
4. What is desired Spending?  
 
Desired spending refers to what people want to spend out of the resources at their 
command. It is also called variously by Keynes as intended, planned or ex ante 
spending. In a three sector economy spending decisions are made by individuals 
(households), firms and the government. The actual purchases made by these three 
groups form three categories of spending: private consumption expenditure (C), 
investment expenditure (I) and government consumption (G). 
 
So in a three sector economy aggregate desired expenditure (AE) consists of desired 
consumption expenditure, desired investment expenditure and desired government 
consumption expenditure. Since the economy is closed there are no exports and 
imports with the other countries. So total desired spending (AE) is only on 
domestically produced goods and services. 
 
Page 5


National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subject: Macroeconomics 
Lesson: National Income Determination in a 
Three Sector Economy 
Lesson Developer : Rajeev Kumar 
College/Department : SRCC, University of Delhi 
  
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
Table of Contents 
 Chapter : National Income Determination in a Three Sector 
Economy 
? 1: Learning Outcomes 
? 2: Introduction 
? 3: First Title 
? 3.1: First Sub-Title 
? 3.2: Second Sub-Title 
? 4: Second Title 
? 4.1: First sub-title 
? 4.2: second sub title 
? Summary  
? Exercises 
? Glossary 
? References 
? Quiz 
 
1. Learning Outcomes 
 
After you have read this chapter, you should be able to  
? Define: Desired Consumption Expenditure, Desired Investment Expenditure, 
Aggregate Expenditure and Aggregate Supply 
? Understand: Aggregate Demand, Aggregate Supply, Components of 
Aggregate Expenditure,  Equilibrium of GDP and Circular Flow of Income in 
three sector economy   
? Identify: The three sector economy, Types of expenditures in three sector 
economy and equilibrium condition   
? Differentiate between two sector and three sector economy, private 
expenditure and public expenditure, investment expenditure and consumption 
expenditure and ex ante and ex post expenditure 
? Appreciate relevance of the determination of income 
? Apply the knowledge of national income determination in three sector 
economy to your other macroeconomic studies and extend the three sector 
model to four sector model by incorporating into it the external sector.  
 
 
2. Introduction 
 
A three sector economy is a closed economy. It has no trade relations with the rest 
of the world. This means that the country does not export or import anything.  In 
this model a private sector and a public sector (government sector) coexist. The 
government and the private sector both invest and consume. The public sector 
regulates the private sector according to the needs of the economy. The public sector 
tries to achieve various objectives like economic growth, macroeconomic stability 
and equitable distribution of income through fiscal policy. 
 
3: Assumptions of the Three Sector Economy Model 
 
Important Assumptions of the Model: The three sector economy model relies upon 
the following key assumptions. : 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
o National Income, national Output, Aggregate Supply and GDP are all treated 
as equivalently. In a closed economy the difference between Gross Domestic 
Product (GDP) and Gross National Income (GNI) is merely the depreciation. 
o The economy is a closed economy having no trade relations with any other 
countries.  
o It is a capitalist and free market economy. It means that individuals are the 
owners of productive resources (land, labour and capital) directly or 
indirectly. 
o There exists a government sector but it does not participate in production 
process. It purchases the output of the private sector. However in reality 
government also produces various goods and services such as health and 
education.  
o It is a short run analysis. The short run helps in analyzing the short run 
deviation of actual GDP from potential GDP or the ‘GDP gap’. It also explores 
how to minimize the magnitude of the negative and positive GDP gaps. 
o It is a constant price model that is price level does not change. 
o It is also assumed that there exists an excess productive capacity in the 
economy. It means the economy can produce more when aggregate demand 
increases without putting an upward pressure upon price level. It also implies 
that every change in GDP will be only in real GDP.  
o It assumed for the sake of simplicity that there is no induced investment 
expenditure.  All Investment expenditures are autonomous that is it does not 
change in response to change in the national income.  
3.1: Classification of the three sectors: 
 
In three sector economy consumption expenditure, Investment expenditure and 
Government expenditure are considered as the three different sectors for the 
purpose of analysis. 
In such an economy government imposes taxes (T) upon the private sector. The 
after tax income or disposable income of the private sector is the difference between 
the GDP or national income and the Taxes paid. 
Y
d
 = Y - T 
Where Yd is the disposable income, Y is the national income and T is the taxes 
collected by the government. 
 
According to the Keynesian psychological law of consumption households consume a 
part of their disposable incomes and save the remaining. So consumption and 
savings are the only two components of disposable national income. 
 
So  
          Y
d
 = Y – T = C + S …………………………(1) 
Where, C and S stand for private consumption expenditure and saving respectively. 
Alternatively by rearranging the equation (1) we get an identity 
           Y = C + S + T …………..……………………(2) 
 
3.1 Supply Side View of A Three Sector Economy  
 
The identity at (2) above also shows the supply side of the economy. It shows flow 
of goods and services in the economy during a period of time. Alternatively it is 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
nothing but the gross domestic product that is the sum of the value of the final 
goods and services produced during a year. In the closed economy only this sum is 
available for the purpose of consumption and investment by the private and the 
public sector both. If government takes away large part of it by charging higher 
taxes less will be left for the private sector’s use.    
 
 
3.2 Expenditure side or demand side view of the three sector economy: 
  
In a three sector economy, aggregate expenditure or aggregate demand is the sum 
of Consumption Expenditure and Investment expenditure of private and government 
sector. 
Alternatively,  
Aggregate Expenditure in a three sector economy = Expenditure in Private Sector + 
Expenditure in government Sector 
However Expenditure in Private Sector has two components: 
i) Private Consumption Expenditure 
ii) Private Investment Expenditure 
Similarly Expenditure in Public Sector has two components: 
i) Government Consumption Expenditure 
ii) Government Investment Expenditure 
Private Consumption Expenditure: Private consumption expenditure is the 
expenditure incurred by the individuals and households on the goods and services for 
final consumption. 
Private Investment Expenditure: The private investment expenditure is that 
expenditure which is incurred by the private sector on creating physical assets like 
tools, machinery, equipments and building.  
Government Consumption Expenditure: Government consumption expenditure is 
that part of the overall expenditure which is incurred in various departments and 
ministries of the government on the goods and services for final consumption. 
Government Investment Expenditure: Government investment expenditure is 
that expenditure which is incurred by various departments and ministries of the 
government on creating physical assets like tools, machinery, equipments and 
building. 
 
 
4. What is desired Spending?  
 
Desired spending refers to what people want to spend out of the resources at their 
command. It is also called variously by Keynes as intended, planned or ex ante 
spending. In a three sector economy spending decisions are made by individuals 
(households), firms and the government. The actual purchases made by these three 
groups form three categories of spending: private consumption expenditure (C), 
investment expenditure (I) and government consumption (G). 
 
So in a three sector economy aggregate desired expenditure (AE) consists of desired 
consumption expenditure, desired investment expenditure and desired government 
consumption expenditure. Since the economy is closed there are no exports and 
imports with the other countries. So total desired spending (AE) is only on 
domestically produced goods and services. 
 
National Income Determination in a Three Sector Economy 
Institute of Lifelong Learning, University of Delhi 
AE = C + I + G …………………………(3) 
 
 
4.1 Desired (ex ante)  and Actual Spending (ex post):  
 
Desired expenditure in an economy may or may not be equal to the actual spending 
for individuals, firms and government individually as well as totally. For example: 
Firms make their investment and production plan for the coming year on the basis of 
past experience. Expected investment in the coming year is the planned investment 
or intended investment of the firm. However the actual investment in the coming 
year may remain more or less than the intended investment because of changed 
economic environment. If the firms expect bumper demand but their expectations 
are not realized there will be unplanned accumulation on inventories (unsold goods, 
unfinished/semi finished goods etc) in the stock of the firms. On the other hand if 
the firms expect low demand but their expectations are not realized there will be an 
unplanned de-accumulation (depletion) of inventories (unsold goods, unfinished/semi 
finished goods etc) in the stock of the firms.  
Therefore  
Actual Investment = Intended Investment ± Inventories Accumulation/ De-
accumulation 
 
In response to the change in inventories producers will alter their production plans to 
meet the desires of demand for goods and services. So the distinction Keynes made 
between ex ante and ex post expenditures is highly crucial in the determination of 
the equilibrium. Equilibrium can only be attained only when expenditure is 
 
 
5. Three Sector Circular Flow of Income:  
In a simple three sector model factor income from the households to the business 
flow through consumption spending, saving and Investment and taxation and 
government spending in the manner shown in the diagram. During the production 
process factors of production earn incomes in the form of wage, interest, rent and 
profit. In such an economy the sum of these factor incomes is equivalent to sum of 
gross value added (GVA) in all the sectors which is equal to the Gross Domestic 
Product at current market prices. 
 
Sum of factor incomes = Sum of Gross Value Added in all the sectors = GDP at 
current market prices 
It is the GDP which flow in the economy in the form of income and expenditure as 
shown in the following flow chart.