Answer to Question #213502 in Macroeconomics for Khushi

Question

Assuming a three sector model of an economy (AD=C+I+G), explain diagrammatically the impact of an increase in transfer payment (made by the government)on the equilibrium level of income.

Answer 1

A three sector economy comprises of Consumption C, Investment I, and Government spending G.

Transfer payment refers to any income that is received or made without any payment of a good or services. This could be a subsidy.

In the image above image, there is impact on the equilibrium income first first by increase in government spending then increase in transfer payment made by the government.

When government spending increases, the aggregate demand curve shifts upward from AD to AD₂ and Income increases to Y₂ .This is because there is a lot of money in the economy. However, when there is increase in transfer payment the income increases from Y₀ to Y₁ . Equilibrium income increases when there is increase in transfer payment by a small margin as compared to increase in government spending. This is because some of the transfer payment is saved.