An economy without government spending or taxation is hardly conceivable today. To make our analysis a realistic one, we assume the existence of the government sector that has the power to spend and collect taxes.

In a two- sector economy, GNP = C + I. But in a three- sector economy, without any trading relation­ship with the outside world, GNP = C + I + G.

Thus, government spending is an important element of aggregate demand or expenditure. Similarly, imposition of taxes by the govern­ment results in a change in disposable income. With the inclusion of taxes in our present analysis, national income becomes

Y = C + S + T

However, basic equilibrium condition in this complicated economy does not change: Aggregate demand (C + I + G) must equal the aggregate output, i.e.,

Y = C + I + G

Alternative equilibrium condition states the equality between leakages and injections, i.e.,

S + T = I + G

If the government does not impose any taxes (i.e., T = 0) to finance its expenditure programme, the equilibrium condition becomes

S = I + G

Determination of Equilibrium Income when C + I + G Line Cuts the 45° Line:

In a three-sector economy with positive govern­ment spending and zero taxes, equilibrium national income is determined when aggregate supply equals aggregate demand. That is to say, equilibrium national income is determined at that point when C + I + G line cuts the 45° line (Fig. 3.16). To explain this, let us assume that, like private investment, government spending is also autonomous.

This means that G is independent of the level of income. CC’ is the consumption function. If autonomous investment of I is added to this consumption line we obtain C + I line. This aggregate private demand (C + I) schedule cuts the 45° line at Et and the corresponding equilibrium level of income is OY1 Now, by adding autonomous public expenditure to private demand, we obtain the aggregate demand function C + I + G. This schedule cuts the 45° line at E1 .The new equilibrium level of income is OY2. Thus, an injection of government spending results in an increase in income and employment.