National Income

National income flows around the economy in a circle. Understanding what adds to that flow, what leaks out of it, and how a single change ripples through it (the multiplier) is the key to this sub-theme.

Learning objectives — by the end of 2.4 you can…

- describe the circular flow of income and distinguish income from wealth; - identify injections and withdrawals and explain their net effect; - explain equilibrium real national output; - explain and calculate the multiplier.

Circular flow, injections & withdrawals

Spec: 2.4.1

The circular flow of income shows money moving between households and firms. Households supply factors of production and receive incomes; they spend those incomes on goods and services, which becomes revenue for firms — and round it goes.

Key Terms

Income vs wealth: Income is a flow (earned per period, e.g. a salary); wealth is a stock (assets owned at a point in time, e.g. property and savings).

Injection: Spending that enters the circular flow from outside household consumption: I, G, X.

Withdrawal (leakage): Income that leaves the flow rather than being spent domestically: S, T, M.

Equilibrium real national output

Spec: 2.4.2

The economy is in macroeconomic equilibrium where aggregate demand equals aggregate supply (AD = AS) — the same point at which injections equal withdrawals (J = W). At this real output, total planned spending exactly matches total planned production, so there is no pressure for output to change.

Equilibrium real output changes whenever AD or AS shifts. A rise in AD (or an outward shift in AS) raises equilibrium output; a fall does the opposite — exactly the AD/AS shifts you drew in 2.2 and 2.3.

The multiplier

Spec: 2.4.3

The multiplier is the idea that an initial change in injections causes a larger final change in national income. When a firm invests £1m, that becomes income for workers and suppliers, who spend part of it, becoming income for others — and so the effect ripples outward.

Marginal propensities

MPC: Marginal propensity to consume — fraction of extra income that is spent.

MPS: Marginal propensity to save.

MPT: Marginal propensity to be taxed.

MPM: Marginal propensity to import.

Every extra £1 of income is either spent or "leaks" out, so MPC + MPW = 1, where the marginal propensity to withdraw is MPW = MPS + MPT + MPM.

$$\text{Multiplier } k = 1 / (1 - MPC) = 1 / MPW$$

where MPW = MPS + MPT + MPM

Worked Example — using the multiplier

Suppose MPC = 0.8 (so households spend 80p of every extra £1).

k = 1 / (1 − 0.8) = 1 / 0.2 = 5.

A £10bn rise in government investment therefore raises national income by 5 × £10bn = £50bn.

Check with leakages: if MPS = 0.10, MPT = 0.05 and MPM = 0.05, then MPW = 0.20 and k = 1 / 0.20 = 5 — the same answer.

Evaluation — the multiplier in practice

- The multiplier is larger when the MPC is high and leakages are low (typical of economies with low import dependence). - Its exact size is hard to predict and it works with time lags. - Near full capacity (a steep/vertical AS), extra AD feeds mostly into inflation rather than real output — so the real multiplier is smaller. - It works in reverse too: a fall in injections causes a magnified fall in income.

2.4 Recap — nail these

Equilibrium real output: AD = AS, equivalently injections = withdrawals (J = W).
The multiplier magnifies an initial injection into a larger change in national income.
k = 1/(1 − MPC) = 1/MPW, where MPW = MPS + MPT + MPM.
Bigger multiplier ⇒ higher MPC / lower leakages; smaller real effect near full capacity.