Three Sector Model: Closed Model with Govt. Sector
- A three sector model comprising households, firms and government is a realistic model because government performs a wide variety of economic activities in a modern economy.
- This model is a closed economy model since there is only three sector – households, business and government sector are involved but the forth sector – foreign or international trade is not involved thus there is an absence of foreign trade.
- To keep our study simple, we will include three main activities of the government, namely 1. Taxes 2. Government spending on factor services and commodities 3. Transfer Payments.
- Government imposes taxes both on households and firms. It levies taxes on households in the form of personal taxes like income tax and indirect taxes like GST, sales tax, excise duties etc. on consumer goods. Therefore a part of the household’s income flows to the government in the form of tax.
- Government imposes taxes on firms as well like corporation tax. Therefore a part of firm’s income also flows from firms to government in the form of corporate tax.
- The government spends the money collected through the taxes to perform various functions in the economy like administration, law and order etc.
- The government spends a part of its tax revenue in purchasing factor services from household and making payment to them in the form of wages and salaries.
- The government also incurs expenditure in buying a whole range of goods and services from the firms and make payments in turn.
- This way income flows from government to households and firms in the form of government expenditure on factor services and purchasing commodities.
- The government incurs expenditure in the form of transfer payments. Transfer payments are unilateral payment for which no real services are rendered in return for them in the current year. Government undertakes various social security and welfare schemes in an economy.
- Old age pension, unemployment allowance, scholarships etc. are examples of transfer payments received mainly by the household.
- Government provides subsidies like fertiliser subsidies and food subsidies to firm in order to encourage production, these are also transfer payments.
- Therefore, there is a flow of money payments from government to households and firms, but there is no reverse real flow.
- The given figure shows primary money flow and real flows between households and firms. But to avoid overcrowding in the diagram, only money flows between government and household as well as government and firms is shown.
- As the households and firms have to pay taxes to the government, part of their income is used to pay taxes which constitute a leakage from the circular flow of income, which results in a fall in the flow of income.
- On the other hand, government pays household factor payment like wages, salaries and also pays to the firms for goods and services. This payment performs as injection in the circular flow. It adds to the aggregate demand and hence results in a rise in income.
- Similarly, transfer payment by the government are also the injections in the circular flows, which will expand the level of circular flow of income.
- If the government spends its entire income received from the households and firms as taxes, in the form of expenditure and transfer payments, then the contraction in level of circular flow due to leakage will be offset by the expansion of the level of circular flow of income due to injection by government. Then there is an equilibrium is set.
- Thus, the equilibrium condition of circular flow of income in three sector (closed economy) model is –
S + T = I + G
- This equilibrium implies that savings plus taxes taken together must be equal to investment and government expenditure taken together.
- If (S+ T) exceeds (I + G) , more income leaks out from flow and is not offset by an equivalent amount of injection which will decrease the flow and hence there is a contraction in this circular flow.
- On the other hand, if (I + G) exceeds (S + T) , the income which leaks out from the flow is offset by more amount of injection, this will increase the flow of income in the circular flow, which results in expansion of circular flow of income.