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In the simple two-sector economy (households and business), investment equals saving. With three sectors (households, business,...

In the simple two-sector economy (households and business), investment equals saving. With three sectors (households, business, and government), this relationship no longer has to hold. Why?

Expert Solution

In two sector model, the income/output equals consumption and investment, ie , where C is consumption expenditure and I is investment expenditure. Also, the household either saves or consumes, as or . But as can be written as , we have the equality , ie .

But, in three sector model, government is included and the income/output equals , where G is government expenditures. Also, the government finances these expenditures by taxes on the househols, as , where T is tax taken to finance the government expenditure, and is a part of income. In this case, we have the expenditure side as or and the income side as or , and we have the equality as , ie .

Hence the relationship doesn't have to hold in three sector economy as it will only hold if or , and the is the government budget deficit.

The equality can be further stated as , referring that if government have a budget surplus or , then household saving must have increased due to less taxes (T) and overcomes the I, and if government have a budget deficit or , then household saving can no longer finance the investment I, as taxes have increased so much that it has cut the household saving. Unless government have a balanced budget, ie , the household saving can not exactly finance the investment in the economy as .

Rahul Sunny answered 1 year ago

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