The Circular Flow of Income (Copy)
9.1.1 The Multiplier Process
Definition of the Multiplier
- The multiplier measures how much national income changes in response to an initial change in autonomous expenditure (e.g., investment, government spending).
- It shows the total increase in income resulting from an initial injection in spending.
- The multiplier effect occurs because one person’s spending becomes another person’s income, generating further spending cycles.
Formulae for the Multiplier
- Basic Formula:
Multiplier = 1 ÷ Marginal Propensity to Withdraw (MPW) - MPW is the fraction of income not spent on domestic goods, i.e., income withdrawn via saving, taxes, and imports.
- Closed Economy without Government:
- MPW = Marginal Propensity to Save (MPS)
- Multiplier = 1 ÷ MPS
- Closed Economy with Government:
- MPW = MPS + Marginal Rate of Tax (MRT)
- Multiplier = 1 ÷ (MPS + MRT)
- Open Economy with Government:
- MPW = MPS + MRT + Marginal Propensity to Import (MPM)
- Multiplier = 1 ÷ (MPS + MRT + MPM)
Propensities Calculations
| Propensity | Definition | Formula |
|---|---|---|
| Average Propensity to Save (APS) | Fraction of total income saved | APS = Savings ÷ Income |
| Marginal Propensity to Save (MPS) | Fraction of additional income saved | MPS = ΔSavings ÷ ΔIncome |
| Average Propensity to Consume (APC) | Fraction of total income consumed | APC = Consumption ÷ Income |
| Marginal Propensity to Consume (MPC) | Fraction of additional income consumed | MPC = ΔConsumption ÷ ΔIncome |
| Average Propensity to Import (APM) | Fraction of total income spent on imports | APM = Imports ÷ Income |
| Marginal Propensity to Import (MPM) | Fraction of additional income spent on imports | MPM = ΔImports ÷ ΔIncome |
| Average Rate of Tax (ART) | Fraction of total income paid as tax | ART = Taxes ÷ Income |
| Marginal Rate of Tax (MRT) | Fraction of additional income paid as tax | MRT = ΔTaxes ÷ ΔIncome |
National Income Determination Using AD and Income Approach with Multiplier
- Aggregate Demand (AD): Sum of consumption (C), investment (I), government spending (G), and net exports (X – M).
- Initial increase in autonomous spending (ΔA) causes a multiplied increase in national income (ΔY).
- Formula:
ΔY = Multiplier × ΔA
9.1.2 Components of Aggregate Demand (AD) and Their Determinants
- Consumption Function:
- C = Autonomous Consumption + Induced Consumption
- Autonomous consumption: spending not dependent on income (e.g., basic necessities).
- Induced consumption: spending that varies with income (dependent on MPC).
- Savings Function:
- Savings = Autonomous Savings + Induced Savings
- Savings increase with income (depends on MPS).
- Investment:
- Autonomous Investment: independent of income (e.g., planned investment).
- Induced Investment: influenced by changes in income via the accelerator effect (investment rises when income rises).
- Government Spending (G):
- Expenditure by government on goods, services, and transfers.
- Net Exports (X – M):
- Difference between exports and imports.
- Determined by foreign income levels, exchange rates, and competitiveness.
9.1.3 Full Employment Level of National Income and Equilibrium Level of National Income
- Full Employment Level:
- National income when all resources (especially labour) are fully employed.
- No cyclical unemployment, only frictional/structural unemployment.
- Equilibrium Level of National Income:
- Where aggregate demand equals aggregate supply (AD = AS).
- Can be below, at, or above full employment.
- Inflationary Gap:
- Equilibrium income exceeds full employment income.
- Excess demand causes upward pressure on prices (inflation).
- Deflationary Gap:
- Equilibrium income below full employment income.
- Insufficient demand causes unemployment and downward pressure on prices (deflation).
Diagrams
Diagram 1: Multiplier Effect in Closed Economy
Initial Increase in Spending
→ ΔA
Total Change in Income
→ ΔY = Multiplier × ΔA
Cycle:
Income → Consumption → Income → Consumption ...
Diagram 2: Aggregate Demand Components
AD = C + I + G + (X - M)
Where:
C = Consumption (autonomous + induced)
I = Investment (autonomous + induced)
G = Government Spending
X = Exports
M = Imports
Diagram 3: National Income Equilibrium and Gaps
Price Level
↑
| AS (Aggregate Supply)
| /
| /
|----------/------------------- Full Employment Income (Yf)
| /
| /
| /
| /
|_____/________________________ AD (Aggregate Demand)
| /
| /
| / Deflationary Gap
| /
| / Inflationary Gap
|__________/__________________→ National Income (Y)
Y1 Yf Y2
- Y1 < Yf → Deflationary Gap (Unemployment)
- Y2 > Yf → Inflationary Gap (Inflation)
Diagram 4: Calculation of Multiplier with Leakages
Multiplier = 1 ÷ (MPS + MRT + MPM)
Leakages: Savings (MPS), Taxes (MRT), Imports (MPM)
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Economics Full Scale Course