The Circular Flow of Income and the Multiplier

This section explores the fundamental concept of the circular flow of income and how changes in aggregate demand (AD) can impact national income. We will focus on the multiplier effect, a key tool for calculating the magnitude of this impact.

Understanding the Circular Flow

The circular flow model illustrates how money and resources move through an economy. It typically involves two main sectors: households and firms.

• Households: Own factors of production (e.g., labour, capital) and consume goods and services.
• Firms: Employ factors of production to produce goods and services, which are then sold to households.

The flow of money represents payments for goods and services, and the flow of factors of production represents the supply of resources to firms.

Aggregate Demand (AD) and National Income (Y)

Aggregate demand (AD) represents the total spending in an economy at a given price level. It is the total demand for goods and services.

National income (Y) is the total value of goods and services produced in an economy over a period, usually a year.

Changes in AD directly impact national income. An increase in AD leads to an increase in output (and therefore national income), while a decrease in AD leads to a decrease in output.

The Multiplier Effect

The multiplier effect describes the magnified impact of an initial change in aggregate expenditure (AD) on national income. It arises because the initial spending becomes income for someone else, who then spends a portion of that income, and so on.

The size of the multiplier depends on the marginal propensity to consume (MPC). The MPC is the proportion of an extra unit of income that households spend on consumption.

The formula for the multiplier (k) is:

$$k = \frac{1}{1 - MPC}$$

Alternatively, the multiplier can be expressed as:

$$k = \frac{1}{1 - MPC}$$

Calculating the Impact of a Change in AD using the Multiplier

To calculate the change in national income resulting from a change in AD, we use the following formula:

$$\Delta Y = k \times \Delta AD$$

Where:

• $\Delta Y$ is the change in national income.
• $k$ is the multiplier.
• $\Delta AD$ is the change in aggregate demand.

Example Calculation

Suppose the MPC is 0.8. The multiplier is:

$$k = \frac{1}{1 - 0.8} = \frac{1}{0.2} = 5$$

If there is an increase in autonomous spending (e.g., investment) of £10 billion, the change in national income will be:

$$\Delta Y = 5 \times 10 = 50 \text{ billion}$$

Therefore, a £10 billion increase in autonomous spending will lead to a £50 billion increase in national income.

Factors Affecting the Multiplier

Several factors can influence the size of the multiplier:

• Marginal Propensity to Consume (MPC): A higher MPC leads to a larger multiplier.
• Marginal Propensity to Save (MPS): The MPS is $1 - MPC$. A higher MPS leads to a smaller multiplier.
• Taxation: Higher taxes reduce disposable income and therefore the MPC, reducing the multiplier.
• Imports: Higher imports reduce the amount of income that remains in the domestic economy, reducing the multiplier.

Conclusion

The multiplier effect is a powerful concept for understanding how changes in aggregate demand can impact national income. By understanding the MPC and other influencing factors, we can better predict the magnitude of these changes.