The three sector economy consists of three economic units, households or the consumers, business firms or producers, and the government. The national output of the economy thus comprises of the monetary value of final consumption (C), final investment goods (I), and final government purchases (G).
Firms and government employ factors of production to produce goods and services. This creates a factor market, where factor payments in the form of wage, rent, interest, and profit are paid to the suppliers of production factors. The summation of such factor payment is termed as national income (NI) at factor cost.
In the three sector economy, households and firms pay taxes to the government, which becomes a source of income for the government. Along with this, households also make saving which gives rise to financial markets. These are the sources of credit to the business firms for making investment. Likewise, the government makes purchases with the help of fund collected through taxes and loan from financial market.
The Keynesian model of three sector economy provides insights on all the important aspects of Keynesian economics. The pattern of household consumption shows the basic induced expenditure through marginal propensity to consume (MPC). Autonomous investment expenditures show how the business cycle is affected. Likewise, government purchases determine the Keynesian fiscal policy for addressing business cycle problems.
Government affects the consumption, production, and investment made by households and firms through taxes and other spending. Transfer payments and subsidies upon private sectors affect their income and saving as well.
Therefore, different fiscal policies can be helpful to describe how equilibrium output/income are determined. In order to determine economy’s equilibrium income/output, three major fiscal policy models can be specified.