There are three sectors in a three sector economy. They are household sector, producer sector and government sector.
Nature of aggreagate demand (AD) curve. AD is the sum of total consumption (C ), Investment (I) and government expenditure (G) in a three sector economy.
Thus, `AD_(1)=C+I+G`
In other words, `(AD_(1)(C+I+G)_(1)` lies above `AD_(0)(C+I)` curve as the governement sector is introduced to sector economy,
`AD_(1)` curve is parallel to `AD_(0)` curve because at every level of output, vertical distance between `AD_(1)` and `AD_(0)` is the constant amount of government expenditure (G).
Figure shows the effect government expenditure on AD. It is clear from the figure that aggreagate demand rises due to inclusion of government sector in the two sector economy Change in Government Expenditure to Correct Excess Demand or Inflationary Gap Excess demand arises when actual level of aggregate demand is higher than required level of aggregate demand to maintain full employment.
To correct excess demand/inflationary gap, the aggregate demand should be reduced by an amount equal to the gap
Observations
1. Economy should be at full employment equilibrium at point E.
2. But actual aggregate demand (AD) is higher than required aggregate demand (AD)) causing excess demand of inflationary gap i.e. FM-EM=EF
3. 3. To correct inflationary gap or excess demand, government will use its fiscal measure by reducing expenditure. 4. Decrease in government expenditure (AG) will bring down the actual AD (AD,) to required AD (AD,).
5. The economy will come back to full employment equilibrium at point 'E' again by removing the inflationary gap or excess demand (EF).
Change in Government Expenditure to Correct Deficient Demand or Deflationary Gap 1. Economy should be at point 'E' to maintain full employment equilibriumn
2. But actual aggregate demand (AD,) is lesser than required level of aggregate demand (AD,) It creates deficient demand or deflationary gap equal to EM- FM EF
3. To correct this gap, government should use its fiscal measure by increasing expenditure.
4. Increase in government expenditure (AG) will bring up the actual `AD(AD_(2))` to required `AD(AD_(0))`
5. The economy will come back to full employment equilibrium at point 'E' again by solving
