National Income

P2 - Topic 4

Circular flow of income

Model of income flowing from firms to households (wages, rent, profit) and spending flowing back from households to firms

Income vs wealth

Income = a flow of money over a period (wages, interest). Wealth = a stock of assets at a point in time (houses, shares, savings)

Injections

Spending added to the circular flow from outside household consumption: investment (I), government spending (G), exports (X)

Withdrawals (leakages)

Income taken out of the circular flow: savings (S), taxation (T), imports (M)

Net injection

I + G + X > S + T + M, so national income rises

Net withdrawal

S + T + M > I + G + X, so national income falls

Equilibrium in the circular flow

Injections = withdrawals (I + G + X = S + T + M)

Equilibrium real national output

Where AD = AS: no tendency for output or the price level to change

Rise in AD (spare capacity)

Higher real output and employment with little inflation

Rise in AD (near full capacity)

Mostly a higher price level with little extra output

Fall in SRAS

Higher price level and lower real output (stagflation)

Rise in LRAS

Higher real output with a lower or stable price level

Multiplier

An initial change in injections causes a larger final change in national income

Multiplier process

One person's spending is another's income, which is partly re-spent, and so on in diminishing rounds

MPC

Marginal propensity to consume: share of extra income spent (ΔC ÷ ΔY)

MPS

Marginal propensity to save: share of extra income saved

MPT

Marginal propensity to tax: share of extra income paid in tax

MPM

Marginal propensity to import: share of extra income spent on imports

MPW

Marginal propensity to withdraw = MPS + MPT + MPM

MPC and MPW relationship

MPC + MPS = 1 in a closed economy. With government and trade, MPC + MPW = 1 (MPC = spending on domestic output)

Multiplier formula (closed, no government)

1 ÷ (1 − MPC) = 1 ÷ MPS

Multiplier formula (open economy with government)

1 ÷ MPW

Multiplier worked example

MPW = 0.4, so multiplier = 1 ÷ 0.4 = 2.5. A $10bn injection raises national income by $25bn

Size of the multiplier

Larger when MPC is high and withdrawals are low. Smaller with high taxes, saving or imports

Significance of the multiplier

An injection shifts AD by more than the initial spending, which strengthens fiscal policy but also amplifies negative shocks

Limits of the multiplier

Hard to estimate, time lags, crowding out, and near full capacity it causes inflation rather than output