Circular Flow of Income and the Multiplier Effect
Hi everyone,
Welcome to Week 9 of A-Level Economics Weekly! This week, we’re covering two foundational topics in macroeconomics: the Circular Flow of Income and the Multiplier Effect. These concepts form the bedrock of understanding how money moves through an economy and the wider impact of changes in spending. Let’s dive in!
The Circular Flow of Income
The Circular Flow of Income is a model that shows how money moves between different sectors of the economy. In its simplest form, it consists of two main sectors:
Households: They provide factors of production (land, labor, capital, and entrepreneurship) to firms and, in return, receive factor incomes (wages, rent, interest, and profit).
Firms: They use the factors of production to produce goods and services, which are then sold to households, creating a flow of goods and services.
Two Types of Flows:
Real Flow: The flow of factors of production from households to firms and the flow of goods and services from firms to households.
Money Flow: The flow of income from firms to households (wages, rent, etc.) and the flow of consumer expenditure from households to firms.
However, this simple two-sector model expands in a real-world context to include other economic agents:
Government: They inject spending into the economy (government expenditure) and withdraw income through taxes.
Financial Sector: Households and firms save money, which the financial sector can lend out, creating investment.
International Trade: Exports are an injection into the economy, while imports are a leakage, reducing domestic income.
Leakages and Injections:
Leakages: These are outflows from the circular flow of income, which include:
Savings (S): Income not spent on consumption.
Taxes (T): Money paid to the government.
Imports (M): Money spent on foreign goods and services.
Injections: These are inflows that add to the circular flow of income:
Investment (I): Spending on capital goods.
Government Spending (G): Expenditure by the government.
Exports (X): Sales of goods and services to foreign buyers.
The balance between leakages and injections determines whether the economy is in equilibrium. If injections exceed leakages, national income grows, while if leakages exceed injections, it shrinks.
The Multiplier Effect
The Multiplier Effect refers to the process by which an initial increase in an injection (like government spending or investment) leads to a greater final increase in national income. This concept is crucial for understanding how economic stimulus works.
How the Multiplier Works:
Imagine the government spends £1 million to build new roads. This spending provides income to construction workers and suppliers, who in turn spend their earnings on goods and services. The businesses they purchase from will then pay wages to their workers, who will also spend a portion of their income, and so on. The result is that the initial £1 million injection leads to a much larger overall increase in national income.
Key Formula:
The size of the multiplier depends on the marginal propensity to consume (MPC)—the proportion of additional income that is spent on consumption. The basic formula for the multiplier is:
Multiplier = 1 / (1−MPC)
(For the more mathematically-minded among you, try proving this! Hint: infinite sum of a geometric series)
For example, if households spend 80% of any extra income they receive (MPC = 0.8), the multiplier would be:
Multiplier = 1 / (1−0.8)
This means that every £1 of new spending generates £5 in additional national income.
Marginal Propensities:
Marginal Propensity to Save (MPS): The fraction of extra income saved rather than spent.
Marginal Propensity to Tax (MPT): The fraction of extra income paid in taxes.
Marginal Propensity to Import (MPM): The fraction of extra income spent on imports.
The larger the MPC, the larger the multiplier effect, as more income is circulated through the economy rather than being saved, taxed, or spent on imports.
Looking Ahead: Week 10 (September 25): Aggregate Demand and Aggregate Supply Analysis
Next week, we’ll be delving into Aggregate Demand (AD) and Aggregate Supply (AS) analysis. You’ll learn how these concepts help to explain price levels, output, and economic growth. Be prepared to explore the factors that shift AD and AS curves, and the implications of those shifts for the wider economy.
See you next week!
Best regards,
Sam
A-Level Economics Weekly