THREESECTOR KEYNESIAN MODEL A Keynesian model of the

THREE-SECTOR KEYNESIAN MODEL: • A Keynesian model of the macro economy that includes the three domestic sectors, the household sector, the business sector, and the government sector. • This Keynesian model variation adds the government sector (or public sector) to the household and business sectors that make up the two-sector model.

• The three-sector Keynesian model is perhaps the most commonly used representation of Keynesian economics. • It contains the three essential components of the macroeconomics needed to analyze business-cycle instability. First, consumption expenditures by the household sector capture induced expenditures.

Second, investment expenditures by the business sector incorporate autonomous private sector expenditure changes that are considered a prime source of business cycles in Keynesian economics. Third, government purchases and taxes by the government sector then highlight the use of policy actions to address business-cycle instability.

• THREE-SECTOR, THREE-MARKET CIRCULAR FLOW: • Three Sectors, Three Markets • The three macroeconomic sectors included in this model are: Household Sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.

Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures. Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. It buys a portion of gross domestic product as government purchases.

• The three macroeconomic markets in this version of the circular flow are: Product markets: This is the combination of all markets in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market. Resource markets: This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.

• Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). • Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

• This diagram presents the three-sector, threemarket circular flow. • At the far left is the household sector, which contains people seeking consumption. • At the far right is the business sector that does the production. At the top is the product markets that exchange final goods and services. • At the bottom is the resource markets that exchange the services of the scarce resources. Just above the resource markets are the financial markets that divert saving to investment expenditures. In the very center is the government sector.

• Illustration 1 • In a two sector economy, the basic equations are as follows: • The Consumption function is C = 200 + 0. 8 Y 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 • Determine the equilibrium level of income in the three sector economy • What is the multiplier effect of the government expenditure? Is it of the same magnitude as the multiplier effect of a change in the autonomous investment? • Presume the Consumption function is C = 200 + 0. 8 Yd 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 • The equilibrium condition in the three sector economy is given as • Y = C+I+G Thus, Y = 200 + 0. 8 Y + 300 + 100 • Or, Y = 600 + 0. 8 Y • Or, Y – 0. 8 Y = 600 • Or, 0. 2 Y = 600 • Or, 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.

• Government Expenditure Multiplier • GM = ΔY = 1 ΔG 1–b • Where, Δ G = Change in government expenditure • b = Marginal propensity to consume • ΔY = Change in income • GM = Government expenditure multiplier • • = 1 / 1 – 0. 80 • = 5 • Investment Multiplier, m = ΔY = 1 ΔI 1–b • Where b is the marginal propensity to consume, • Thus the magnitude of the multiplier effect is the same as that of a change in government expenditure.

• • • Thus, C = G = T = 100 millions 200 + 0. 8 (Y -100) we know (Yd=Y-T) C = 200 – 80 + 0. 8 Y C = 120 + 0. 8 Y But, Y = C+I+G Y = 120 + 0. 8 Y + 300 + 100 Y – 0. 8 Y = 120 + 400 0. 2 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.

• Illustration 2 • In an economy, the full employment output occurs at 2000 millions. The marginal propensity to consume is 0. 8 and the equilibrium level of output is currently at 1600 millions. Suppose the government aspires to achieve the full employment output, find the change in • The level of government expenditures • Net lump sum tax

• Solution • We have, GM = • ΔY = 1 ΔG 1 -b • Where, Δ G = Change in government expenditure • b = Marginal propensity to consume • ΔY = Change in income • GM = Government expenditure multiplier • For instance, • b = 0. 80 • ΔY = 2000 – 1600 • ΔY = 400 • Thus, 400 / Δ G = 1 / 1 - 0. 8 • ΔG = 400 (0. 2) • Thus, the level of government expenditures required to achieve the full employment output is 80 millions

• We have, GF = • Where, • consume ΔY ΔT = -b 1–b ΔT b = = Change in tax marginal propensity to • ΔY = Change in income • GF = Government tax multiplier • As the tax multiplier is negative, an increase in tax leads to a decrease in the equilibrium level of income. • For instance, b = 0. 80 • ΔY = 2000 – 1600 = 400 Thus, 400 = - 0. 80 ΔT 1 – 0. 80 • -0. 8 Δ T = 400 (0. 20) • The net lump sum tax is – 100 millions. There should be a decrease in lump sum tax by 100 millions