Summary circular flow of income

Macroeconomics
A LEVEL, 9.0




Ludovica Magni

,9.1 The Circular Flow of Income
the circular flow and national income
In an economy, households provide factors of production such as labour to firms, and in
return they receive income in the form of wages, rent, interest and profit. Firms use these
factors to produce goods and services, which are then bought by households. This
continuous movement of income and expenditure is known as the circular flow of income.

National income depends on the level of aggregate demand (AD) in the economy. When
aggregate demand increases, firms produce more, leading to higher incomes, which in
turn generate further spending. This process explains how changes in spending can lead
to larger changes in national income. This is known as the multiplier process.

The Multiplier Process
The multiplier measures the ratio of the change in national income to an initial change in
autonomous spending (such as investment, government spending or exports).

In simple terms, it shows how an initial injection of spending leads to a larger final increase
in national income due to repeated rounds of spending.

This happens because one person’s spending becomes another person’s income, part of
which is then spent again

Leakages and injections

Not all income is spent. Some of it is withdrawn from the circular flow through leakages,
while spending enters the flow through injections.

 Leakages: savings (S), taxes (T), imports (M)

 Injections: investment (I), government spending (G), exports (X)

The size of the multiplier depends on the size of leakages: the greater the leakages, the
smaller the multiplier.

The multiplier formula

 Closed economy and no government, only savings
⇒ 1 : MPS
(marginal propensity to save), portion of each euro of income that is not spent

 Closed economy with government, savings + tax
⇒ 1 : (MPS + MRT)
(marginal rate of tax), portion of income that goes in tax.

 Open economy with government, savings + tax + imports
⇒ 1 : (MPS + MRT + MPM)

, Marginal propensity to import, income spend in foreign assets.

As the economy becomes more open and government involvement increases, the
multiplier becomes smaller.

Propensities

Propensities show how income is divided between spending and leakages.

 Consumption
- APC (average propensity to consume) = Consumption ÷ Income, how much
is spent of the income.
- MPC (marginal propensity to consume) = Change in consumption ÷ Change
in income, for every additional euro earned, how much is spent.


 Saving
- APS (average propensity to save) = Saving ÷ Income
- MPS (marginal propensity to save) = Change in saving ÷ Change in income


 Imports
- APM (average propensity to import) = Imports ÷ Income
- MPM (marginal propensity to import) = Change in imports ÷ Change in
income


 Taxes
- ART (average rate of tax) = Tax ÷ Income
- MRT (marginal rate of tax) = Change in tax ÷ Change in income



A higher marginal propensity to withdraw income (save, tax or import) reduces the
multiplier. (multiplier uses only MARGINAL)



National income determination using AD and the multiplier

National income is determined where aggregate demand equals aggregate output.

Using the income approach:

Y=C+I+G+(X−M)

An increase in autonomous spending (for example, investment) causes aggregate demand
to rise. Through the multiplier process, this leads to a larger increase in national income
than the initial injection.