9.1 The Circular Flow of Income

Chapter 9.1 – The Circular Flow of Income and National Income Determination

9.1.1 The Multiplier Process

Definition:
The multiplier measures how much national income increases as a result of an initial change in injections (like investment or government spending). It explains how expenditure creates income and leads to further spending.

Multiplier Formulas:

• Basic (2-sector closed economy):
  k = 1 / (1 – MPC) or k = 1 / MPS

• With government (3-sector):
  k = 1 / (MPS + MRT)

• Open economy with trade and taxes (4-sector):
  k = 1 / (MPS + MRT + MPM)

Key Propensities and Rates:

• APC (Average Propensity to Consume) = C / Y

• APS (Average Propensity to Save) = S / Y

• APM (Average Propensity to Import) = M / Y

• MPC (Marginal Propensity to Consume) = ΔC / ΔY

• MPS (Marginal Propensity to Save) = ΔS / ΔY

• MPM (Marginal Propensity to Import) = ΔM / ΔY

• MRT (Marginal Rate of Tax) = ΔT / ΔY

Where:

• C = consumption

• S = savings

• M = imports

• T = taxes

• Y = income

• Δ = change

Key Rule:
A larger leakage (higher MPS, MPM, MRT) leads to a smaller multiplier.

Example:
If MPC = 0.8, then MPS = 0.2, and the multiplier is:
k = 1 / 0.2 = 5

So, a $100 million injection increases national income by $500 million.

9.1.2 Components of Aggregate Demand (AD)

AD = C + I + G + (X – M)
Where:

• C = consumption

• I = investment

• G = government spending

• X = exports

• M = imports

1. Consumption (C)

• Autonomous consumption: occurs even when income is zero.

• Induced consumption: rises with income.

• Consumption function:
  C = a + bY
  Where:

• a = autonomous consumption

• b = MPC

• Y = income

Factors affecting consumption:

• Disposable income

• Interest rates

• Wealth

• Expectations

• Consumer confidence

2. Savings (S)

• Savings function (derived from income and consumption):
  S = -a + (1 – b)Y

Factors affecting saving:

• Interest rates

• Income level

• Inflation

• Government incentives

3. Investment (I)

• Autonomous investment: not dependent on income

• Induced investment: varies with economic output

• Accelerator theory:
  Investment is related to the rate of change in national income, not just the level.
  I = f(ΔY)

Factors affecting investment:

• Interest rates

• Business confidence

• Government policies

• Expected returns

4. Government Spending (G)

• Autonomous; can increase AD directly.

• Used for fiscal policies to influence economic activity.

Determinants:

• Policy decisions

• Political priorities

• Debt levels

• Tax revenue

5. Net Exports (X – M)

• Export earnings add to AD; import payments reduce AD.

• Net exports depend on:

• Exchange rates

• Foreign income

• Domestic income

• Trade agreements

9.1.3 Equilibrium and Full Employment National Income

Equilibrium National Income
Occurs when:
Aggregate Demand (AD) = Aggregate Supply (AS)
or
Injections (I + G + X) = Withdrawals (S + T + M)

In equilibrium, there’s no tendency for output or income to change.

Full Employment Level of National Income
This is the maximum sustainable level of output an economy can produce when all resources are fully used. It is also known as potential output.

Gaps in National Income:

• Inflationary Gap:
  When AD > full employment output.
  Leads to demand-pull inflation. Requires contractionary policy.

• Deflationary Gap:
  When AD < full employment output.
  Leads to unemployment. Requires expansionary policy.

Graphical Representation (suggest diagram insert in WP):

• 45° Keynesian Cross (AD = Y)

• AD/AS diagram to show inflationary and deflationary gaps

Summary Table