Circular flow of Income

The circular flow of income is a model that represents how national income flows around an economy.

Circular flow of income diagram

Injections

Money that flows into the circular flow of income that can cause national income to grow.

  • Investments
  • Government Spending
  • Exports

Withdrawals

  • Savings
  • Tax
  • Imports

Sectors

  • A 2 sector model is simplified and only includes Households and Firms (the model above).
  • A 3 sector model includes the government, showing tax and government spending
  • A 4 sector model includes international trade

National income changes

\(Injections = Investments + Government Spending + Exports\)
\(Withdrawals = Savings + Tax + Imports \)

  • If injections = withdrawals then the national income stays the same.
  • National income will increase if injections > withdrawals
  • National income will decrease if injections < withdrawals

Calculating GDP

GDP Can be calculated in three different ways. These a different lines on the diagram:

  • Output Method
    • Measure the total value of goods and services produced by firms
  • Income Method
    • Measure the total amount of income received from firms -> households
  • Expenditure Method
    • Measure the total amount of expenditure, households -> firms (AD is the formula for this)

All three of these are equal and will give the same answer.

Multiplier Effect

The multiplier effect of the final impact of an injection on an economy.

\(\text{Multiplier} = \frac{1}{MPW}\)

MPW - Marginal Propensity to Withdraw (leakage) - What proportion of money given to the economy will be leaked.

\(\text{MPW} = \text{MPS} + \text{MPI} + \text{MPT}\)

MPS - Marginal Propensity to Save - What proportion of the money will you save if given £100 MPI - Marginal Propensity of Imports
MPT - Marginal Propensity of Tax

Propensity - What proportion of money given to you will go to something.

The Multiplier Effect Process

The government injects £200m in a project to build thousands of affordable new homes

  • £200m in extra demand in the economy
  • Many businesses benefit directly, such as building supply industries, archetects.
  • Constructing new homes means wages and profits flow in the circular flow of income

Will the extra incomes stay inside the circular flow of income?

  • If yes, the multiplier effect is likely to be strong and resultant impact on GDP quite large

If the value of the multiplier is 1.5, then the final impact is £300m If the value of the multiplier is 1.25, then the final impact is £250m

Multiplier effect example

Assume that for each £100 of extra income

  • 10% (0.1) is saved (S)
  • 20% (0.2) is taken in taxation (T)
  • 20% (0.2) leaks from the economy due to imports (M)

The money repeatedly circulates the economy until it is completely leaked out.

  • £200m injection ->
    • £20m saved
    • £40m taxed
    • £40m imports
  • £100m extra GDP ->
    • £10m saved
    • £20m taxed
    • £20m imports
  • £50m extra GDP...

\(\text{Multiplier} = \frac{1}{0.1 + 0.2 + 0.2} = \frac{1}{0.5} = 2\)

So the effect of investment of £100m will be \(£100\text{m} * 2 = £200\text{m}\)

Simple Multiplier

The simple multiplier only considers savings. The only leakage is saving. Taxes and imports are ignored.

\(\text{Multiplier} = \frac{1}{1-\text{MPC}} = \frac{1}{\text{MPS}}\)

Causes of a high Multiplier

  • The economy has plenty of spare capacity (i.e a negative output gap) to meet higher AD
  • Marginal Propensity to import and tax is low
  • High propensity to consume any extra income (i.e low propensity to save)
  • New infrastructure projects often have higher multiplier effect