The circular flow of income

Households own the factors of production and supply them to firms. Firms pay factor incomes (wages, rent, interest, profit) for them, and households spend that income on the firms' output. Income flows round in a circle — hence the three ways of measuring national income are identical: output = income = expenditure.

Income vs wealth (2.4.1b). Income is a FLOW — money received per period (a £35,000 salary per year). Wealth is a STOCK — the value of assets held at a point in time (a house, a pension pot, shares). Income can be used to accumulate wealth; wealth can generate income (rent, dividends). Wealth in the UK is distributed far more unequally than income — and rising asset prices raise wealth inequality without touching income at all.

Injections and withdrawals

• Injections (J) = Investment + Government spending + Exports. Spending that enters the circular flow from outside the household–firm loop. Injections increase national income.
• Withdrawals / leakages (W) = Savings + Taxation + Imports. Income that leaves the circular flow and is not passed on as demand for domestic output. Withdrawals reduce national income.

If injections exceed withdrawals, more is being spent on domestic output than is leaking out, so firms raise output and national income rises — until the higher income generates enough extra savings, tax and imports to restore J = W. The adjustment is automatic, and it happens through the multiplier process.

Injection, withdrawal, or neither?

Careful — some of these are internal flows within the circle, not injections or withdrawals at all.

Equilibrium in the AD/AS model

Equilibrium real national output occurs where AD = AS. This determines both the equilibrium real output (Y) and the equilibrium price level (P) at the same time.

Reconciling the two models. The circular flow says equilibrium is where J = W. The AD/AS model says equilibrium is where AD = AS. These are the same statement. Injections (I + G + X) and withdrawals (S + T + M) are precisely the elements that determine AD, so J = W is the condition under which planned expenditure equals output and there is no tendency for income to change.

The multiplier process

An injection does not raise national income by just its own value. The money is spent and re-spent. Every pound one person spends is another person's income — and they spend part of it too.

Trace it through. The government spends £100m on a new railway. Assume MPC = 0.8 (so MPW = 0.2).

The intuition: the multiplier is large when leakages are small — because more of each round of spending stays in the domestic circular flow and comes round again. A high MPS, a high tax rate or a high propensity to import all shrink the multiplier.

It works in reverse. A negative multiplier amplifies a cut in injections. Austerity that cuts G by £10bn with a multiplier of 1.5 reduces real GDP by £15bn — which is why the IMF publicly conceded in 2013 that it had underestimated fiscal multipliers in the post-2008 austerity programmes, and had therefore underestimated the damage.

Match the propensity to its meaning

All four are fractions of each extra pound of income.

Your turn — multiplier from the MPC

Your turn — multiplier from the MPW

Your turn — the final change in real GDP

Your turn — work backwards

What makes the multiplier bigger?

Injections and withdrawals

Why the multiplier matters

• It magnifies every AD shift. The AD curve shifts right by far more than the initial injection — by the injection times k. Any policy that changes I, G or (X − M) has an amplified effect.
• It amplifies the trade cycle. A fall in investment in a downturn is multiplied into a much larger fall in GDP. Combined with the accelerator (2.2.3), it produces the boom-and-bust dynamics of 2.5.
• It is central to fiscal policy design. If k = 2, £10bn of extra spending buys £20bn of GDP — and the extra tax revenue from that growth partly pays for itself. If k = 0.5, it does not.
• It makes the composition of a stimulus matter. Spending targeted at low-income households (who have a high MPC) or on domestically-produced infrastructure (low import content) has a bigger multiplier than a tax cut for the rich (high MPS) or a subsidy for imported goods.

Evaluation — why the real multiplier is smaller than the formula suggests. ❶ Crowding out: if the economy is near full capacity, government borrowing raises interest rates and bids resources away from the private sector, so private I and C fall as G rises. ❷ Spare capacity: if there is none, extra AD raises prices, not real output (2.3 classical LRAS) — the real multiplier collapses towards zero. ❸ Time lags: the rounds of spending take months or years. ❹ MPW is not constant: it changes with confidence and with income. ❺ Ricardian equivalence: if households expect today's borrowing to mean tomorrow's taxes, they save the stimulus instead of spending it. The multiplier is biggest exactly when it is needed most — in a deep recession with idle resources, where crowding out is minimal.

When is the multiplier small?

Income and wealth

The big ideas to know

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