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Difficulty: MediumCircular Flow of Income

In a closed three-sector economy consisting of households, business firms, and the government, planned household savings (SS) is $65 billion\$65\text{ billion}, net government tax revenue (TT) is $35 billion\$35\text{ billion}, and private investment expenditure (II) is $45 billion\$45\text{ billion}. For the circular flow of income to be in equilibrium, what must be the level of government expenditure (GG)?

  1. A
    $15 billion\$15\text{ billion}
  2. $55 billion\$55\text{ billion}Answer
  3. C
    $75 billion\$75\text{ billion}
  4. D
    $100 billion\$100\text{ billion}

Answer

The level of government expenditure required for circular flow equilibrium is $55 billion\$55\text{ billion}.
In a three-sector model of the circular flow of income (Households, Business Firms, and Government), national income equilibrium requires total leakages (S+TS + T) to equal total injections (I+GI + G). Adding household savings ( me$65 billion\ me\$65\text{ billion}) and government taxes ( me$35 billion\ me\$35\text{ billion}) gives total leakages of $100 billion\$100\text{ billion}. Setting investment ( me$45 billion\ me\$45\text{ billion}) plus government expenditure (GG) equal to $100 billion\$100\text{ billion} yields G=$55 billionG = \$55\text{ billion}.

Step-by-Step Solution

1
Identify total leakages (withdrawals) from the circular flow
Total Leakages = S+T=$65 billion+$35 billion=$100 billionS + T = \$65\text{ billion} + \$35\text{ billion} = \$100\text{ billion}
In a three-sector economy, leakages consist of savings (SS) and net taxes (TT).
2
Set total injections equal to total leakages
Total Injections (I+GI + G) = Total Leakages (S+TS + T) = $100 billion\$100\text{ billion}
Equilibrium in the circular flow of income occurs when total planned injections equal total planned leakages.
3
Solve for government expenditure (GG)
$45 billion+G=$100 billion  ⟹  G=$100 billion−$45 billion=$55 billion\$45\text{ billion} + G = \$100\text{ billion} \implies G = \$100\text{ billion} - \$45\text{ billion} = \$55\text{ billion}
Subtract investment (II) from total injections to find the required government expenditure (GG).

Key Concept

Circular flow equilibrium in a 3-sector economy (S+T=I+GS + T = I + G)
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Topics

Circular Flow of Income

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