5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

TwoSectors,ThreeSectorsandFourSectorModelofNational
IncomeDetermination
bySmritiChandNationalIncome

Advertisements:

TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination!

Introduction:
Tosimplifytheanalysis,ithasbeenclassifiedintoatwosectormodel,athreesectormodelandafour
sectormodel.

Firsttwosectorsarerelatedtoaclosedeconomyinwhichthereisnoforeigntradeandthelastsectoris
concernedwiththeopeneconomy.

TwoSectorModel:
Atwosectormodelofincomedeterminationofaneconomyconsistsonlyofdomesticandbusiness
sectors.

Assumptions:
Theincomedeterminationinaclosedeconomyisbasedonthefollowingassumptions:

1.Itisatwosectoreconomywhereonlyconsumptionandinvestmentexpenditurestakeplace.Thus
thetotaloutputoftheeconomyisthesumofconsumptionandinvestmentexpenditure.

2.Investmentrelatestonetinvestmentafterdeductingdepreciation.

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 1/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

3.Itisaclosedeconomyinwhichtherearenoexportsorimports.

4.Therearenocorporatefirmsintheeconomysothattherearenocorporateundistributedprofits.

5.Therearenobusinesstaxes,noincometaxesandnosocialsecuritytaxessothatdisposablepersonal
incomeequalsNNP.

6.Therearenotransferpayments.

7.Thereisnogovernment.

8.Thereisautonomousinvestment.

9.Theeconomyisatlessthanfullemploymentlevelofoutput.

10.Thepricelevelremainsconstantuptotheleveloffullemployment.

11.Themoneywagerateisconstant.

12.Thereisstableconsumptionfunction.

13.Therateofinterestisfixed.

14.Theanalysisrelatestotheshortperiod.

Explanation:
Giventheseassumptions,theequilibriumlevelofnationalincomecanbedeterminedbytheequalityof
aggregatedemandandaggregatesupplyorbytheequalityofsavingandinvestment.

Aggregatedemandisthesummationofconsumptionexpenditureonnewlyproducedconsumergoods
byhouseholdsandontheirservices(C),andinvestmentexpenditureonnewlyproducedcapitalgoods
andinventoriesbybusinessmen(I).

Itisshownbythefollowingidentities:

Y=C+I.(1)

PersonalIncome:Yd=C+S.(2)

ButY=Yd

C+I=C+S

OrI=S

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 2/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

WhereY=nationalincome,Yd=disposableincome,C=consumption,S=saving,andI=investment.

Intheaboveidentities,C+lrelatetoconsumptionandinvestmentexpenditureswhichrepresent
aggregatedemandofaneconomy.Cistheconsumptionfunctionwhichindicatestherelationbetween
incomeandconsumptionexpenditure.

TheconsumptionfunctionisshownbytheslopeoftheCcurveinFig.1whichisMPC(marginal
propensitytoconsume).Iisinvestmentdemandwhichisautonomous.Wheninvestmentdemands(I)
isaddedtoconsumptionfunction(C),theaggregatedemandfunctionbecomesC+I.

C+Sidentityisrelatedtotheaggregatesupplyofaneconomy.Thatiswhy,consumergoodsand
servicesareproducedfromtotalconsumptionexpenditureandaggregatesavingsareinvestedinthe
productionofcapitalgoods.

Inaneconomy,theequilibriumlevelofnationalincomeisdeterminedbytheequalityofaggregate
demandandaggregatesupply(C+I=C+S)orbytheequalityofsavingandinvestment(S=I).

WeexplainthesetwoapproachesonebyonewiththehelpofFigure1(A)and(B).

EqualityofAggregateDemandandAggregateSupply:
Theequilibriumlevelofnationalincomeisdeterminedatapointwheretheaggregatedemand
function(curve)intersectstheaggregatesupplyfunction.Theaggregatedemandfunctionis
representedbyC+Iinthefigure.ItisdrawnbyaddingtotheconsumptionfunctionCtheinvestment

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 3/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

demandI.

The45linerepresentstheaggregatesupplyfunction,Y=C+S.TheaggregatedemandfunctionC+I
intersectstheaggregatesupplyfunctionY=C+SatpointEinPanel(A)ofFigure1andtheequilibrium
levelofincomeOYisdetermined.

Supposethereisdisequilibriuminaggregatesupplyandaggregatedemandoftheeconomy.
Disequilibriumcanbeineithercase,aggregatesupplyexceedingaggregatedemandoraggregate
demandexceedingaggregatesupply.Howwilltheequilibriumlevelofincomeberestoredinthetwo
situations?

First,takethecasewhenaggregatesupplyexceedsaggregatedemand.ThisisshownbyOY2levelof
incomeinPanel(A)ofthefigure.HereaggregateoutputorsupplyisY2E2andaggregatedemandis
Y2k.ThedisposableincomeisOY2(=Y2E2).AtthisincomelevelOY2,consumerswillspendY2don
consumptiongoodsandsavedE2.

Butbusinessmenintendtomakeinvestmentequaltodkinordertobuyinvestmentgoods.Thusthe
aggregatedemandforconsumptiongoodsandinvestmentgoodsisY2d+dk=Y2k.Butaggregate
supply(oroutput)Y2E2isgreaterthanaggregatedemandY2kbykE2(=Y2E2Y2k).

Therefore,thesurplusoutputofgoodsworthkE2accumulatedbybusinessmenintheformof
unintendedinventories.Inordertoavoidfurtherinventoryaccumulation,theywillreduceproduction.
Asaresultofthereductioninoutput,incomeandemploymentwillfallandtheequilibriumlevelof
incomewillberestoredatOYwheretheaggregatesupplyequalsaggregatedemandatpointE.

Thesecondsituationofdisequilibriumwhenaggregatedemandexceedsaggregatesupplyisshownby
theincomelevelofOY1inPanel(A)ofthefigure.HeretheaggregatedemandisY1E1andthe
aggregateoutputisY1a.ThedisposableincomeisOY1(=Y1a).

Atthisincomelevel,consumersspendY1bonconsumptiongoodsandsaveba.Butbusinessmen
intendtoinvestbE,tobuyinvestmentgoods.ThustheaggregatedemandisY1b+bE1=Y1E1whichis
greaterthantheaggregatesupplyofgoodsY1abyaE1.

TomeetthisexcessdemandworthaE1,businessmenwillhavetoreduceinventoriesbythisamount.In
ordertostopfurtherreductionintheirinventories,businessmenwillincreaseproduction.Asaresult
oftheincreaseinproduction,output,incomeandemploymentwillincreaseintheeconomyandthe
equilibriumlevelofincomeOYwillberestoredagainatpointE.

EqualityofSavingandInvestment:
Theequilibriumlevelofincomecanalsobeshownbytheequalityofthesavingandinvestment
functions.Sincetheequilibriumlevelofincomeisdeterminedwhenaggregatesupply(C+S)equals
aggregatedemand(C+I)intheeconomy,intended(orplanned)savingalsoequalsintended(or

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 4/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

planned)investment.Thiscanbeshownalgebraically

C+S=C+l

S=I

TheequilibriumlevelofincomeintermsoftheequalityofsavingandinvestmentisshowninPanel(B)
ofFigure1,whereIistheautonomousinvestmentfunctionandSisthesavingfunction.Thesaving
andinvestmentfunctionsintersectatpointEwhichdeterminestheequilibriumlevelofincomeOY.

Ifthereisdisequilibriuminthesenseofinequalitybetweensavingandinvestment,forceswilloperate
intheeconomyandtheequilibriumpositionwillberestored.SupposetheincomelevelisOY2whichis
abovetheequilibriumincomelevelOY.

AtthisincomelevelOY2,savingexceedsinvestmentbygE2.Itmeansthatpeopleareconsumingand
spendingless.Thusaggregatedemandislessthanaggregatesupply.Thiswillleadtotheaccumulation
ofunintendedinventorieswithbusinessmen.Toavoidfurtheraccumulationofinventories,
businessmenwillreduceproduction.Consequently,output,incomeandemploymentwillbereduced
tilltheequilibriumlevelofincomeOYisreachedatpointEwhereS=I.

Onthecontrary,iftheincomelevelislessthantheequilibriumlevel,investmentexceedssaving.This
isshownbyOY1levelofincomewheninvestmentY1E1isgreaterthansaving.Theexcessofintended
investmentoverintendedsavingmeansthataggregatedemandisgreaterthanaggregatesupplyby
eE1.

Sinceaggregateoutput(orsupply)islessthanaggregatedemand,businessmenwilldecrease
inventoriesheldbythem.Tostopfurtherreductionintheirinventories,theywillincreaseproduction.
Consequently,output,incomeandemploymentwillincreaseintheeconomyandtheequilibriumlevel
ofincomeOKwillbeagainreachedatpointE.

Thedeterminationofequilibriumlevelofincomesimultaneouslybytheequalityofaggregatedemand
andaggregatesupplyandofsavingandinvestmentisexplainedinTableIbelow.

Table1

ThreeSectorModel:
Athreesectormodelofincomedeterminationconsistsofatwosectormodelandthegovernment
sector.Thegovernmentincreasesaggregatedemandbyspendingongoodsandservices,andby
http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 5/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

collectingtaxes.

GovernmentExpenditure:
First,wetakegovernmentexpenditure.Toexplainit,givenalltheaboveassumptions
exceptthegovernmentsectorinthetwosectormodel,incomedeterminationisas
follows:

Byaddinggovernmentexpenditure(G)toequation(1)ofthetwosectormodel,YC+l,wehave

Y=C+I+G

Similarly,byaddinggovernmentexpenditure(G)tothesavingandinvestmentequation,whenwehave

Y=C+I+G

Y=C+S[S=YC]

I+G=S

BothareillustratedinFigure2(A)and(B).InPanel(A),C+I+Gisthenewaggregatedemandcurve
whichintersectstheaggregatesupplycurve45lineatpointE1whereOY1istheequilibriumlevelof
income.ThisincomelevelismorethantheincomelevelOYwithoutgovernmentexpenditure.

Similarly,accordingtotheconceptofsavingandinvestment,thenewinvestmentcurveI+Gintersect
thesavingcurve5atpointinPanel(B).Consequently,theincomelevelOY1isdeterminedwhichis
morethantheincomelevelOYwithoutgovernmentexpenditure.

Itshouldbenotedthatbyaddinggovernmentexpendituretoconsumptionandinvestment
expenditure(C+I),thenationalincomeincreasesbyYY1whichismorethanthegovernment
expenditure,Y>GinPanel(A)ofthefigure.Thisisduetothemultipliereffectwhichdependsupon
thevalueofMPCorMPSwhereMPCorMPS<1.

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 6/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

Taxation:
Nowweexplaintheeffectsoftaxesonthelevelofnationalincome.Whenthegovernmentimposesa
tax,theamountoftaxisreducedfromthenationalincomeandwhatremainsisthedisposableincome.
Thus

YT=Yd

WhereYnationalincome,T=tax,andYd=disposableincome.Nowdisposableincomewillbeless
thannationalincomebytheamountoftax,Yd<Y.Withthefallindisposableincome,peoplewill
reduceexpenditureonconsumption.Thiswillleadtoreductioninnationalincome,whichwilldepend
ontheamountorrateoftaxandthevalueofMPC.

Givenalltheabovementionedassumptionsinwhichgovernmentexpenditureisconstant,theeffects
oftaxesonnationalincomeareillustratedinthefollowingfigures.

First,theeffectofalumpsumtaxonincomeisshowninFig.3.Theequilibriumlevelofincome
withoutataxisatpointEwheretheaggregatedemandcurve(C+I+G)intersectstheaggregatesupply
curve45lineandtheincomelevelOYisdetermined.Byimposingalumpsumtax,theconsumption
functionisreducedbytheamountoftax.

Asaresult,theaggregatedemandcurveC+I+GshiftsdownwardstoC1+I+Gandintersectsthe
aggregatesupplycurve45lineatpointE1.ThisresultinthereductionofincomelevelfromOYto

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 7/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

OY1Thuswiththeimpositionofalumpsumtax,thenationalincomeisreducedbyYY1.

Nowwetakeaproportionaltaxwhichisimposedonincomeasaconstantpercentage.Withthe
increaseintherateoftax,consumptionandnationalincomewilldecreaseandviceversa.Theeffectof
suchataxonincomelevelisshowninFigure4.

TheaggregatedemandcurveC+I+Gbeforetheimpositionoftaxintersectstheaggregatesupplycurve
45lineatpointEandtheincomelevelOYisdetermined.Afterimposingthetax,theC+I+Gcurve
shiftsdownwardtoC1+I+Gduetoafallinconsumption,anditintersectsthe45lineatpoint
E1consequently,theequilibriumlevelofnationalincomeisreducedbyYY1.

EffectonSavingandInvestment:
Theeffectofataxonsavingandinvestmentalsodeterminestheequilibriumofnational
incomeasfollows:

Y=C+I+G

AndY=C+S+T

Y=C+I+G=C+S+T

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 8/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

OrK=I+G=S+T

Itisclearfromtheaboveequationthatwhenplannedinvestment(I)plusgovernmentexpenditureon
goodsandservices(G)equalplannedsaving(S)plustax(T),theequilibriumofnationalincomeis
established.I+GareinflowsorinjectionsinthenationalincomeandS+Tareoutflowsorleakages.If
theyareequaltoeachother,thenationalincomeisinequilibrium.

ThisisshowninFig.5.Here,EistheequilibriumpointbeforeimposingthetaxwhereSandI+Gcurve
intersectsandtheincomelevelOYisdetermined.Withtheimpositionofatax,theScurveshifts
upwardtotheleftasS+TandthenewequilibriumisestablishedatpointE1withI+Gandthenational
incomefallsfromOKtoOY1.

FourSectorModel:IncomeDeterminationinOpenEconomy:
Weshallnowshowhownationalincomeisdeterminedinanopeneconomy.Forthis,werelaxthe
assumptionsthattherearenoexportsorimportsandgovernmentexpenditures.Thismeansthatwe
shallhavetoaddimportsandexportsandgovernmentexpendituresandtaxationinouranalysis.

Itmaybenotedthatgovernmentexpendituresarelikeinvestmentbecausetheyraisethedemandfor
goods.Theyareinjectionsinthenationalincome.Ontheotherhand,taxesareleakagesinthenational
incomelikesavingsbecausetheytendtoreducethedemandforconsumergoods.

Theimpactofexportsandimportsissimilartothatofthegovernmentexpenditure.Exportsare
injectionsbecausetheyincreasethedemandforgoodsinthesameeconomy.Imports,ontheother
hand,areleakagesinthenationalincomebecausetheyrepresentthesupplyofgoodstothegiven
economy.

Assumptions:
Theanalysisofthedeterminationofincomeinanopeneconomyisbasedonthe
followingassumptions:

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincome 9/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

1.Thedomesticeconomysinternationaltradeissmallrelativetototalworldtrade.

2.Thereislessthanfullemploymentintheeconomy.

3.Thegeneralpricelevelisconstantuptothefullemploymentlevel.

4.Exchangeratesarefixed.

5.Therearenotariffs,tradeandexchangerestrictions.

6.Grossexportsaredeterminedbyexternalfactors.

7.Exports(A),investment(I)andgovernmentexpenditure(G)areautonomous.

8.Consumption(C),imports(M),savings(S)andtaxes(I)areeachafixedproportionofnational
income(Y)andtheirrelationshipswithnationalincomearelinear.

DeterminationofEquilibriumLevelofIncome:
Giventheseassumptions,anopeneconomyisinequilibriumwhenitsnationalexpenditure(E)isequal
toitsnationalincome(Y).

Thiscanbeshowninthefollowingequationfortheequilibriumlevelofincome:

Y=E=C+I+G+(XM)

ButY=C+S+T

C+S+T=C+I+G+(XM)

Intheaboveanalysis,C+S+Tisgrossnationalincome(GNI)andC+I+G+(XM)isgrossnational
expenditure(GNE).Thustheequilibriumlevelofincomeinaneconomyisdeterminedwhenaggregate
supply,GNI=GNE,aggregatedemand,or,C+S+T=C+I+G+(XM).

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincom 10/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

ThisisshowninFigure6whereCistheconsumptionfunction.Onthiscurve,Tautonomous
investmentissuperimposedtoformtheC+Ifunction,andautonomousgovernmentexpenditureGis
superimposedonC+ItoformtheC+I+Gfunction.WhennetexportsofXMaresuperimposedon
C+I+G,wegettheaggregatedemandfunctionC+I+G+(XM).The45lineistheaggregatesupply
functionwhichrepresentsC+S+T.

ItshouldbenotedthatsolongasC+I+G+(XM)>C+I+G,exportsexceedimportsandthereisnet
additiontoaggregatedemand.AtpointDinPanel(A)ofthefigure,XM=O.Beyondpoint
D,C+I+G>C+I+G+(XM)andimportsexceedexports,andthisgapcontinuestogrowasincome
increases.Thisleadstonetreductioninaggregatedemandsothattheaggregatedemandfunction
C+I+G+(XM)liesbelowthedomesticdemandfunctionC+I+G.

Theequilibriumlevelofincomeinanopeneconomy,OYisdeterminedatpointEwheretheaggregate
demandfunctionC+I+G+(XM)intersectstheaggregatesupplyfunctionC+S+T.

Thisanalysisshowsthatintheabsenceofforeigntrade,theequilibriumlevelofincomewouldhave
beenatahigherlevel,asdeterminedbytheequalityofC+I+G=C+S+TatpointFwhereaswithforeign
tradeitisatalowerpointE.

Thereisalsoanalternativemethodfordeterminingtheequilibriumlevelofincomeinanopen
economyintermsofsavingandinvestmentequality.

Accordingly,

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincom 11/12
5/15/2016 TwoSectors,ThreeSectorsandFourSectorModelofNationalIncomeDetermination

C+S+T=C+I+G+(XM)

OrS+T=I+G+(XM)

OrS+T+M=I+G+X

WhereS+T+MreferstototalincomeandI+G+Xtototalexpenditure.WhenS+T+Misequalto
I+G+X,theequilibriumlevelofincomeisdetermined.ThisisshowninPanel(B)ofFig.6wherethe
S+T+McurveintersectstheI+G+XcurveatpointEandtheequilibriumlevelofincomeOYis
determined.

http://www.yourarticlelibrary.com/macroeconomics/nationalincomemacroeconomics/twosectorsthreesectorsandfoursectormodelofnationalincom 12/12