Ans: The three-sector model is formed by adding the government sector to the two-sector model

 A three-sector model includes (a) Households, (b) Firms, and (c) Government. It depicts (shows) a more realistic economy. Government plays an important role in the economy. Government makes many fiscal operations. In this simple analysis, we consider only three fiscal variables of government. These are (i) Taxes, (ii) Government Expenditure, and (iii) Transfer Payments. 

(i) TAXES: Taxes are withdrawals from the flows. Because they reduce private disposable income, consumption expenditure, and savings. 

(ii) GOVERNMENT EXPENDITURE: Government expenditure is an injection to the circular flows. Because it adds to the aggregate demand. Here, the government purchases factor services from the households and goods and services from the firms. 

(iii) TRANSFER PAYMENTS: The transfer payments by the government (e.g. old-age pension, unemployment, allowances, subsidies, etc.,) are injections to the circular flows. They add to the income of households who raise demand for consumer goods. 

This three-sector model is shown in the following figure: 

Income Flows to Government (Withdrawals): Households pay some part of their income to the government in the form of direct taxes. 

Similarly, firms also pay corporate income tax to the government, firms also pass on to the government indirect taxes which are collected from households. The government taxes reduce - disposable income and consumption of households, - sales and income of firms, - production and investment in the economy, and - the size of circular flows. Thus, with the introduction of government and collection of taxes by it, the magnitude of flows between households and firms is reduced. Because part of their income flows to the government sector. The situation is damaged by the government. Now, the government itself corrects this situation through its spending and transfer payments.

 (Injections): Government spends a part of its tax revenue on wages and salaries paid to the households. It also makes transfer payments like old-age pension and unemployment allowances to households. Likewise, the government spends a part of its tax revenue on the purchase of goods and services from the firm. It also pays subsidies to firms.

Thus, the money that flows from households and firms to the government in the form of taxes flows back to these sectors in the form of government expenditure and transfer payments. 

Therefore, T is withdrawal and G is injection. The net effect of T and G on the size of flows depends on whether T and G are equal or not. The budgetary policy of the government determines whether tax revenue and government expenditure are equal or not.

è If the government adopts a balanced budget policy, then G = T. 

è If the government adopts a deficit budget policy, then G > T.

è If the government adopts a surplus budget policy, then G < T. The balanced and deficit budget policies indicate injections into the economy. So, they expand circular flows. On the other hand, a surplus budget policy indicates withdrawal from the economy. So it reduces circular flows. 

 The total expenditure (E), in the economy, is the sum of consumption expenditure (C), 

Investment expenditure (I), government expenditure (G). Symbolically, E = C + I + G ……… (i) The total income (Y) received is allocated to the consumption (C), Savings (S), and Taxes (T). Symbolically, Y = C + S + T …. (ii) Total expenditure is equal to total income (E = Y) Therefore, form (i) and (ii), we have, C + I + G = C + S + T …. (iii) Since C occurs on both sides, it will be cancelled out. Now we have I + G = S + T …(iv) Here, injections such as I and G are equal to withdrawal such as S and T. By re-arranging equation …..(iv) G – T = S – I …….(v) OR (I – S) + (G –T) = 0