INCOME DETERMINATION MODEL

The Three-Sector Income Determination Model in Macroeconomics

Introduction
The Three-Sector Income Determination Model is a critical framework in intermediate
macroeconomics that explains how the economy's national income (or GDP) is determined in the
presence of three major sectors: households, businesses, and the government. This model extends
the simple two-sector income determination model (households and businesses) by introducing
government spending, taxation, and other governmental economic activities. Understanding the
interactions between these sectors is essential for analyzing the equilibrium national income and
the effects of fiscal policies, such as government expenditure and taxation.
This model assumes that the economy is closed with no foreign trade, so there is no external
sector. Additionally, it is based on the classical assumption that investment is determined by
interest rates, but we will focus on how government spending and taxation interact with
consumption and investment to determine national income.
1. The Basic Framework
The three-sector model assumes the following:
Households: Households supply labor to firms and receive wages in return. They consume goods
and services produced by businesses.
Firms/Businesses: Firms produce goods and services using the factors of production (labor,
capital) provided by households. They also invest in capital to increase production capacity.
Government: The government collects taxes and injects spending into the economy through
various public expenditures (e.g., infrastructure, healthcare, education). The government can
affect the equilibrium income level through fiscal policies.
The key variables in the model are:
Y = National income (or GDP)
C = Consumption
I = Investment
G = Government expenditure
T = Taxes
S = Savings
Yd = Disposable income, which is Yd = Y – T
The relationship among these variables is central to determining the equilibrium income level in
the economy.

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2. The Consumption Function
The consumption function expresses the relationship between consumption and disposable
income. It is generally assumed that consumption is a function of disposable income, and it is
written as:
C = C0 + c⋅(Y − T)
Where:
C0 = Autonomous consumption (consumption when income is zero)
c = Marginal propensity to consume (MPC), which represents the fraction of additional income
that households consume
Y - T = Disposable income (income after taxes)
This equation shows that consumption depends on the level of disposable income. As income
increases, consumption increases, but not one-for-one (because of the MPC).
3. The Investment Function
Investment is typically assumed to depend on the level of national income and interest rates.
However, in this simplified version, we assume that investment is determined by factors other
than income, such as business expectations, interest rates, and other variables. For this model, the
investment function is:
I = I0
Where I0 is the autonomous level of investment. In this context, we are assuming that investment
is exogenous and fixed, meaning it does not change with income directly.
4. Government Sector
The government collects taxes and makes expenditures. Government spending G is assumed to
be exogenous (not influenced by income), and taxes T are generally assumed to be a fixed
proportion of income, i.e.:
T = t⋅Y
Where:
t is the average tax rate (0 < t < 1).
Therefore, the government's fiscal policy can directly affect national income through changes in
G and T.
5. Equilibrium Condition
The equilibrium level of national income is determined where total spending (expenditure) in the
economy equals total output (income). Total expenditure is the sum of consumption C,

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investment I, and government spending G. Therefore, the aggregate demand (total expenditure)
is:
AD = C + I + G
In equilibrium, aggregate demand equals national income Y:
Y=C+I+G
Substitute the consumption function C = C0 + c⋅(Y − T) into the equation:
Y = C0 + c⋅(Y - T) + I0 + G
Substitute T = t⋅Y into the equation:
Y = C0 + c⋅(Y − t⋅Y) + I0 + G
Simplifying:
Y = C0 + c⋅(1−t)⋅Y + I0 + G
Rearrange the terms to isolate Y:
Y − c⋅(1−t)⋅Y = C0 + I0 + G
Factor out Y:
Y[1 − c⋅(1 − t)] = C0 + I0 + G
Solve for Y:
C 0 + I 0 +G
Y=
1−C . (1−t )
This is the equilibrium national income in the three-sector model.
6. Interpretation of the Result:
The equilibrium national income Y depends on several factors:
Autonomous consumption C0: An increase in autonomous consumption (such as through higher
government transfers or lower interest rates) increases equilibrium income.
Investment I0: An increase in investment (such as through business expansion or fiscal stimulus)
also increases equilibrium income.
Government spending G: An increase in government expenditure directly raises equilibrium
income, as government spending is a component of aggregate demand.
Tax rate t: The higher the tax rate t, the lower the equilibrium income, as a larger portion of
income is taxed away, leaving less disposable income for consumption.

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The denominator 1 − c⋅(1 − t) reflects the "multiplier effect." This term shows how much
national income responds to changes in autonomous spending (like C 0, I0, or G). The larger the
marginal propensity to consume cc, the larger the multiplier effect, as households spend more of
each additional dollar of income. Likewise, the smaller the tax rate t, the larger the multiplier,
because less income is taxed away, leaving more disposable income to be spent.
7. Mathematical Illustration:
Let’s consider the following numerical values to illustrate the model:
C0 = 100 (autonomous consumption)
c = 0.8 (marginal propensity to consume)
t = 0.2 (tax rate)
I0 = 200 (autonomous investment)
G = 300 (government spending)
The equilibrium income Y would be:
100+200+ 300
Y=
1−0.8 ( 1−0.2 )
Simplifying:
600
Y=
0.36
Y = 1666.67.
So, the equilibrium national income is approximately Y = 1666.67.

The Multiplier Concept

The multiplier concept in macroeconomics explains how an initial change in economic activity
(such as investment or government spending) leads to a larger overall impact on the national
income or GDP. The multiplier effect occurs because an initial injection of spending creates
income for individuals or businesses, which in turn leads to more spending and further increases
in income and output.
The Multiplier Effect in a 3-Sector Economy
The multiplier (denoted as k) is the factor by which an initial change in autonomous spending
(whether it be consumption, investment, or government expenditure) is magnified to determine
the total change in national income.
The formula for the multiplier in this model is:

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 1
k=
1−c
Where:
c is the marginal propensity to consume (MPC).
Explanation:
A higher c (the marginal propensity to consume) means that households are more likely to spend
any additional income they receive. This leads to a larger multiplier effect because more of the
income is re-spent, stimulating further production and income generation.
A lower c implies that households are more inclined to save than consume additional income,
leading to a smaller multiplier.
Deriving the Multiplier Effect
Let’s now explore how the multiplier works in action by analyzing the impact of a change in
autonomous spending (such as a change in government expenditure or investment).
If there is an increase in government spending (ΔG), the initial effect is an increase in income
(since G is a component of aggregate demand).
As income increases, consumption rises because households will consume more based on the
increased income.
This additional consumption leads to further increases in income, leading to further increases in
consumption, and so on.
Each round of spending is smaller than the previous one because not all income is consumed
(some of it is saved). This process continues until the total effect on income is determined.
To show this mathematically, if the government increases spending by ΔG, the change in income
ΔY is:
1 1
∆ Y =k ∙ ∆ G= = ∙∆G
1−c 1−c

Thus, a change in government spending (ΔG) results in a larger change in national income ΔY,
with the magnitude determined by the multiplier.
Numerical Example of the Multiplier
Given the following:
Autonomous consumption (C0) = 50
Autonomous investment (I0) = 30

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Government spending (G0) = 40
Marginal propensity to consume (c) = 0.75
First, we calculate the equilibrium income:
C 0 + I 0 +G
Y=
1−C . (1−t )

50+30+ 40
Y=
1−0.75

120
Y=
0.25

Y = 480

Thus, the equilibrium income is 480.

Now, if government spending increases by ΔG = 10, the change in income will be:

1
∆Y = ∙∆G
1−c

1
∆Y = ∙ 10
1−0.75

1
∆Y = ∙ 10
0.25

ΔY = 40
Therefore, an increase in government spending by 10 will lead to a total increase in income of
40.
The Role of the Multiplier in Policy Analysis

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The multiplier is a key concept for understanding how fiscal policies (such as changes in
government spending or taxation) impact the overall economy. Policymakers often rely on the
multiplier effect to design fiscal policies that stimulate economic activity.
Expansionary fiscal policy (e.g., increased government spending or tax cuts) can boost
aggregate demand and increase national income. The larger the multiplier, the more effective
such policies will be.
Conversely, contractionary fiscal policy (e.g., reducing government spending or increasing
taxes) can reduce aggregate demand and lower national income.
8. Limitations of the Multiplier Effect
While the multiplier concept is valuable, it is not without limitations:
Crowding Out: In the real world, government spending may not always increase income by the
predicted amount because of the crowding-out effect. This occurs when increased government
spending leads to higher interest rates, which may reduce private investment.
Leakages: Some of the income generated may leak out of the domestic economy through
savings or imports, which reduces the effectiveness of the multiplier.
Time Lags: The multiplier effect assumes that the economy adjusts instantaneously, but in
reality, there are often significant time lags in the response to changes in policy.
CONCLUSION
The three-sector income determination model provides a useful tool for understanding the
relationships between consumption, investment, government spending, and taxes in determining
national income. By adjusting government policies (such as changing tax rates or increasing
government spending), the government can influence the overall economic activity and achieve
macroeconomic goals such as full employment or price stability.
This model highlights the importance of fiscal policy in shaping national income levels and the
multiplier effect, showing that changes in autonomous spending can lead to greater-than-
proportional changes in national income. It also illustrates how taxation affects the equilibrium
level of income by reducing disposable income and consumption. Understanding this model is
essential for analyzing the broader macroeconomic environment and formulating effective
economic policies.
The multiplier in the 3-sector income determination model illustrates how changes in
autonomous spending can lead to larger changes in national income. The size of the multiplier
depends on the marginal propensity to consume, and policymakers must consider its implications
when designing fiscal policies. Understanding the multiplier effect is essential for analyzing the
broader economic impact of government spending and investment decisions.

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