National Income
National Income
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People earn money from businesses and spend it on what businesses make, so money moves in a circle.
Vandria is a country with an open economy, which means it trades with other countries. To see how its economy works, split it into two groups. Households are the groups of people in Vandria who live together in one home. They own the factors of production, the resources used to produce anything: labour (work), land, capital (machines and buildings) and enterprise (organising production and taking its risks). Firms are the businesses that use these factors to produce goods and services, called their output.
Things move between the two groups. Households supply their factors to firms, and firms supply goods and services to households. This movement of real things is called the real flow.
Each of these things is paid for. Firms pay households for their factors: wages for labour, rent for land, interest for capital and profit for enterprise. Interest is what a firm pays for money it borrows from households, for example to buy machines. All these payments are called income. Households then spend their income on the firms' goods and services. This movement of payments is called the money flow.
Why does the money flow run the opposite way to the real flow? Because a thing goes one way, and the payment for it goes back the other way. Households give their labour to firms, so firms pay wages to households. Firms give bread to households, so households pay firms for the bread. This simple model leaves out trade with other countries and the government, and in it households spend all their income on firms' output. The money firms pay out therefore comes back to firms, and the model is drawn as a circle.
Circular flow of income: a model of the economy that shows how income, spending and output flow between households and firms.
Put simply, it is a map of where each dollar goes: from firms to households as income, and back to firms as spending.
National income: the total income earned by the factors of production in an economy over a period of time, usually a year.
Put simply, it adds up every wage, rent, interest payment and profit earned in a country in one year. On the circle, it is the income that flows from firms to households. Vandria's national income is $600bn a year.
The same dollars can be counted at three points on the circle, and each count gives the same total.
Follow one dollar around Vandria's circle. On its way it passes three points, and at each point all the dollars passing it in a year are added up. National output is the value of all the goods and services an economy produces in a year, measured by what they sell for. National income is the income paid to the factors of production that produced that output. National expenditure is the total spending on that output in a year.
Why are the three totals equal? Start with spending and output. In this simple model, households spend all their income on Vandria's goods and services, and firms sell all that they produce. So the total spent equals the value of the output.
Now output and income. A firm sells what it produces, so the money from its sales, called its revenue, is the value of its output. From its revenue, a firm pays wages to its workers, rent for its land and interest on the money it borrowed for capital. Whatever is left after these payments is called profit, and it goes to the firm's owners as their income.
So every dollar of a firm's revenue is paid to someone as income. If a firm's revenue and its other payments stay the same and its wages rise by $10, its profit is $10 smaller. If its wages fall by $10, its profit is $10 larger. Either way, the payments still add up to the whole revenue. This is why income and output are exactly equal, not roughly equal.
In Vandria, each of the three counts gives $600bn a year, because all three measure one flow at different points. For the same reason, a change in one is a change in all three. If Vandria's firms produced and sold $10bn more output in a year, national income and national expenditure would each be $10bn higher too.
Some money figures are measured over a period, and others on a single date.
Hana is a nurse in Vandria. She earns $24,000 a year from her job. On 1 January, her flat and her savings, the money she has kept from past pay, are worth $90,000.
The first figure is measured over a period: a year. It is a flow, which means an amount that moves over a period of time, like water through a pipe. The second is measured on one date. It is a stock, which means an amount that exists at one moment, like the water in a tank. Her flat and savings are assets, which means things she owns that have a value. Her flat is property: land or a building that someone owns. Shares are assets too: a share makes its owner one of the owners of a business.
Income: a flow of money received over a period of time, such as wages, rent, interest and profit.
Put simply, income is money arriving: Hana's $24,000 arrives over the whole year, not on one day.
Wealth: the stock of assets owned at a point in time, such as property, savings and shares.
Put simply, wealth is a snapshot of what you own: Hana's flat and savings on 1 January.
The key difference is time. An income figure needs a period, and a wealth figure needs a date. Without the period or the date, the figure means little: $24,000 a month is twelve times as much income as $24,000 a year. For the same reason, income and wealth cannot be added into one total. Hana's $24,000 is measured over a year and her $90,000 on 1 January, so their sum would mean nothing.
Income and wealth are linked in two ways. In the simple circular flow, households spend all their income, but a real household such as Hana can keep part of hers. The part of her pay that Hana keeps in the bank each month adds to her savings, so her wealth grows. Wealth can also earn income: a bank, a firm that looks after people's savings, pays interest on them, and the owner of a flat can rent it to a tenant, someone who pays to live in it.
The circular flow shows payments made over a period, so income is part of it. Wealth is not a payment: it is what someone owns on a date, so it is not part of the flow. Only the income that wealth earns, such as rent and interest, enters the flow.
Some money enters Vandria's circular flow from outside it, and some income leaves it.
In the simple circular flow, households spend all their income on firms' output, so every dollar returns to a firm. Vandria's real economy does not work like this. Its government and buyers in other countries also buy from Vandria's firms. And not all income is spent on Vandria's domestic output (the goods and services made in Vandria).
So money can cross the edge of the circle in two directions, and each direction has a name.
Injection: spending on an economy's output that does not come from the income of its households.
Put simply, an injection is money that reaches Vandria's firms from outside the circle. It adds to the flow.
Withdrawal: income that is not spent on an economy's output.
Put simply, a withdrawal is income that leaves the circle before it reaches a firm in Vandria. It takes money out of the flow.
The key difference is the direction. An injection crosses the edge of the circle inwards, as spending on Vandria's output. A withdrawal crosses it outwards, as income that is not spent on Vandria's output. There are three of each, and they come in pairs:
What decides is the direction in which the money crosses the edge, not who spends it. Vandria's government is on both sides: a tax takes income out of the flow, and paying a firm to build a road adds spending to the flow. A household's spending is never an injection, but it can stay inside the flow or leave it. Bread from a bakery in Vandria stays inside the flow, so it is neither an injection nor a withdrawal. A phone made abroad is an import, because the money pays a producer outside Vandria.
Investment adds to the flow only when firms buy newly made machines and buildings, because only then is something produced.
A furniture firm in Vandria needs saws, sewing machines and a workshop. These are capital goods: things a firm uses to produce other goods and services, often for many years.
Investment (I): spending by firms on capital goods, such as machinery, equipment and buildings.
Put simply, investment is a firm buying the tools it will work with, not the things it will sell.
Investment is an injection, because the spending comes from firms, not from households' income. In Vandria, investment is $70bn a year.
When a firm buys a new machine, a machine maker in Vandria produces it and pays wages for the work. So the spending creates output and income. Buying shares (parts of the ownership of a company) is different. So is buying a factory that already exists. Each one only changes who owns something that already exists. Nothing new is produced, nobody is paid to produce it, and no spending enters the flow.
Investment also has a second effect. Every injection adds to spending this year. But a new machine also lets a firm produce more output in the years that follow, so investment can raise how much the economy is able to produce later.
When a government buys goods and services, its spending enters the circular flow as an injection.
Vandria's government pays teachers, builds roads and buys medicines for its hospitals. Each time, it pays for something that people or firms produce.
Government expenditure (G): spending by the government on goods and services.
Put simply, it is the government acting as a buyer: a teacher's salary pays for a service, and a new road is a good.
Government expenditure is an injection, because the money comes from the government, not from households' income. In Vandria it is $110bn a year. It is also the injection that a government chooses. It sets the amount in its budget (its plan of spending and taxes for the year). Investment depends on many firms' decisions, and exports depend on buyers in other countries.
But not every payment a government makes is government expenditure. Some payments buy nothing at all.
Transfer payment: a payment from the government for which no good or service is given in return, such as a pension or unemployment benefit.
Put simply, a transfer moves money from the government to a household, and the household gives nothing back for it. Unemployment benefit, for example, is paid to people who have lost their jobs.
Why is a transfer not counted as government expenditure? A pension buys no good or service, so no firm produces anything and nobody earns income from it. The pension turns into spending on output only later, when the pensioner (the retired person who receives it) spends it in a shop. That spending is then counted as household spending, inside the flow, like any other spending from a household's income. If the pension were also counted as government expenditure, the same dollar would be counted twice.
Exports bring spending from other countries into Vandria's circular flow.
A coffee farm in Vandria sells some of its beans to cafés in Vandria. It sells the rest to firms in other countries. The second kind of sale is an export.
Exports (X): goods and services produced in one country and sold to buyers in other countries.
Put simply, an export is anything made in Vandria that a buyer in another country pays for.
Exports are an injection, because the buyers earned their income in other countries. That money comes from outside Vandria's circular flow, but it buys Vandria's output and becomes income for the farm and its workers. In Vandria, exports are $60bn a year.
Exports include services, not only goods. Suppose a family from another country spends a week in a hotel in Vandria. Nothing is shipped anywhere, but foreign income buys a service produced in Vandria, so the hotel stay is an export. To decide whether a sale is an export, ask where the output was produced and where the buyer earned the money. Whether goods cross a border does not matter. A family from Vandria that pays for a week in a hotel abroad is the opposite case: an import.
Exports are also the injection a government controls least. They depend on the incomes of buyers in other countries. When incomes there fall, those buyers are likely to buy less of Vandria's output, and Vandria's government cannot easily change that.
Real Example: The Maldives, an island country in the Indian Ocean, sells hotel stays to foreign tourists. The number of visitors arriving fell from about 1.7 million in 2019 to about 555,000 in 2020, during the COVID-19 pandemic, a worldwide outbreak of disease. Fewer visitors meant less foreign spending in its hotels, so its exports of services are likely to have fallen. It shows how a country's exports can fall when fewer foreign visitors come.
Income that households save is earned but not spent, so it leaves the circular flow.
Hana, a nurse in Vandria, pays income tax on her pay. What is left is her disposable income: the income a household has after tax, to spend or to keep. She spends most of it on food, rent and transport. This spending by households on goods and services is called consumption. The part she does not spend goes into her bank account.
Saving: the part of disposable income that is not spent on consumption.
Put simply, saving is the part of your pay that you keep instead of spending.
Savings are a withdrawal. Hana earned the money, so it is income. But she did not spend it, so no firm in Vandria receives it this year. Spending in the flow is smaller than income by that amount. In Vandria, households save $60bn a year.
This does not make saving bad for the economy. Banks lend saved money to firms, which means firms can use it now and pay it back later with interest. If a firm borrows the money and spends it on new machines, that spending is investment, an injection. But firms decide for themselves whether to borrow and invest, for their own reasons. So savings and investment do not have to be equal. In Vandria, savings are $60bn and investment is $70bn.
Saved income can also add to a household's wealth, the value of what it owns on a date. Each year that Hana saves, the money in her bank account grows.
Tax on income takes part of it before it can be spent, so taxation is a withdrawal.
When Hana is paid, part of her pay goes straight to Vandria's government as income tax. Firms in Vandria also pay tax on their profits.
Taxation (T): money that households and firms must pay to the government, such as income tax.
Put simply, taxation is the part of what people and firms earn that goes to the government before they can use it.
Taxation is a withdrawal. The money was earned as income, but the household never spends it on Vandria's output, so it leaves the flow when the tax is taken. In Vandria, taxation is $120bn a year.
But the government spends most of its tax money again, on teachers, roads and medicines. That spending is counted separately, as government expenditure, an injection. So why are taxation and government expenditure not counted as one figure? There are two reasons. The government decides them separately: how much to tax, and how much to spend. And they are rarely the same size.
Now reverse the sizes. Suppose a government collects $90bn in tax and spends $100bn. It injects $10bn more than it withdraws, so firms sell more, and on its own its taxing and spending makes the flow likely to grow in the next period. If tax and spending were counted as one figure, you could not see whether the government adds to the flow or takes from it.
Imports are income that is spent, but on another country's output, so the money leaves Vandria's flow.
Hana buys a new phone. If the phone was made in Vandria, her spending pays a firm in Vandria and stays in the flow. If it was made in another country, her spending pays a producer in that country.
Imports (M): goods and services produced in other countries and bought by buyers in this country.
Put simply, imports are what Vandria's people, firms and government buy from the rest of the world.
Imports are a withdrawal. The household did spend the money, but not on Vandria's output: the spending pays producers in another country, so it becomes income in that country's circular flow, not in Vandria's. No firm in Vandria produced the phone, and nobody in Vandria earned income from making it. In Vandria, imports are $60bn a year.
Imports work the opposite way to exports. With an export, a buyer abroad pays for Vandria's output, so money enters the flow. With an import, a buyer in Vandria pays for another country's output, so money leaves it. In Vandria, imports of $60bn equal exports of $60bn, so through buying and selling with other countries as much leaves the flow as enters it. In many countries the two are not equal, and then trade on its own adds to the flow or takes from it.
Imports can still be useful. A firm in Vandria that buys an imported machine may produce more in later years. But the money pays a producer abroad, not a firm in Vandria, so that spending is an import and leaves the flow.
What changes national income is the gap between total injections and total withdrawals.
Vandria has three injections and three withdrawals. To see what happens to the flow, compare their totals.
Net injection: when total injections are greater than total withdrawals.
Put simply, more money enters the circle than leaves it, so firms receive more spending than the income they paid out.
Net withdrawal: when total withdrawals are greater than total injections.
Put simply, more money leaves the circle than enters it, so firms receive less spending than the income they paid out.
Suppose firms in Vandria buy more new machines, and investment rises by $20bn to $90bn. Nothing else changes at first. Total injections become $260bn, against withdrawals of $240bn: a net injection of $20bn. Its effect takes time. Firms first see their sales change, and only then change how much they produce, so national income changes in the next period (the next few months or year), not at once.
Now take the opposite case. Incomes fall in the countries that buy from Vandria, and exports fall by $20bn to $40bn. Total injections become $220bn, against withdrawals of $240bn: a net withdrawal of $20bn. Each step of the chain reverses: less enters the flow as injections than leaves it as withdrawals, so firms receive less spending than the income they paid out. They sell less, produce less and pay out less income, so national income falls in the next period.
Suppose instead that savings and investment both rise by $10bn. Investment is an injection and savings a withdrawal, so each total rises by $10bn, to $250bn. The totals are still equal, so there is no net injection or net withdrawal, and national income does not change. Only the gap between the two totals moves the flow.
Exam Matters: In an answer, give both totals before and after the change. Then name the net injection or net withdrawal before you say what happens to national income.
National income settles where injections equal withdrawals, because any gap between the two totals closes itself.
In Vandria, national income is $600bn a year. Injections add up to $240bn, and withdrawals also add up to $240bn. As much enters the flow as leaves it, so there is no net injection and no net withdrawal. Nothing makes the circular flow grow or shrink.
National income is the same as national output, and here it is measured in real terms. Real means measured at constant prices, so a rise in real output means more goods and services, not only higher prices.
Equilibrium level of real national output: the level of real output at which injections equal withdrawals, so there is no tendency for it to change.
Put simply, it is the size the circular flow keeps from one year to the next, because what enters the flow each year is exactly what leaves it.
But what if national income moves away from $600bn? Withdrawals rise with income: in Vandria, 40 cents of each dollar of income is saved, paid in tax or spent on imports. In this simple model, injections do not depend on this year's income. They come from firms' plans, the government's budget and foreign buyers, so they stay at $240bn. Total spending on Vandria's output is then the part of income that households spend on it, plus the injections.
So above $600bn the flow shrinks, and below it the flow grows. Either way, the gap closes without anyone acting: as income changes, withdrawals change with it, until they equal injections again at $600bn.
An equilibrium is not the highest output the economy could produce. It is only the level at which injections equal withdrawals, and that level can be too low to give every worker a job. So Vandria could stay at $600bn while many workers have no job. National income moves away from $600bn only when the injections, or the share of each dollar that is withdrawn, change.
The same equilibrium can be drawn on a second diagram, which also shows what happens to prices on average.
The circular flow shows that Vandria's national income settles at $600bn, but not what happens to prices. A second diagram shows both. It compares planned spending, what buyers intend to spend, with planned output, what firms intend to produce. It also uses the price level: the average of all prices in the economy. The price level is shown as an index: the average is set at 100 in a starting year, so a price level of 105 means prices are 5% higher on average.
Aggregate demand (AD): the total planned spending on goods and services produced in an economy, at a given price level, over a given period of time.
Put simply, AD is all the spending that buyers plan on Vandria's goods and services in a year. It has four parts: consumption (C) by households, investment (I) by firms, government expenditure (G), and exports (X) bought by foreign buyers. Households, firms and the government also spend some of their money on imports (M), goods and services made abroad, not in Vandria. That spending does not buy Vandria's output, so imports are subtracted. So AD = C + I + G + (X − M).
Aggregate supply (AS): the total output that firms in an economy plan to supply at each price level over a given period of time.
Put simply, AS is the output Vandria's firms plan to produce in a year, and it can differ at each price level. The key difference is who plans: AD is the spending that buyers plan, and AS is the output that firms plan to produce.
On an AD/AS diagram, the price level goes up the vertical axis and real national output along the horizontal axis. AD is drawn sloping down, because buyers plan to spend more on Vandria's output when the price level is lower. AS is drawn sloping up, because firms plan to supply more when the price level is higher. They cross at E, the point where real national output is $600bn and the price level is 100. At E, the spending buyers plan equals the output firms plan to supply, so there is no tendency for real output to change.
Why is this the same $600bn that the circular flow gives? AD counts the same spending: what households spend on Vandria's output out of their income, plus the injections. In Vandria, withdrawals take $240bn of the $600bn of income, so households spend $600bn − $240bn = $360bn on Vandria's goods and services, and injections add $240bn. So planned spending is $600bn, equal to what firms produced, and that is also where AD meets AS. The two diagrams show one equilibrium.
When AD shifts, real output and the price level move in the same direction.
AD shifts when planned spending on Vandria's goods and services changes at every price level. A change in any part of AD = C + I + G + (X − M) shifts it. For example, households spend more when they feel confident about their jobs. Firms invest more when interest rates (the cost of borrowing) fall. Foreign buyers buy more of Vandria's exports when their own incomes rise. They also buy more when Vandria's currency (its money) falls in value against theirs, because its goods then cost them less in their own money.
Each of these is a change in an injection or a withdrawal. Investment, government spending and exports are injections. When households feel confident, they spend more of their income and so save less of it, and saving is a withdrawal. A rise in an injection adds spending on Vandria's output, so AD shifts right. A fall in a withdrawal, such as households saving less, leaves more income to spend on it, so AD shifts right too. A rise in a withdrawal means less income is spent on Vandria's output, so AD shifts left.
Suppose incomes rise abroad, and foreign buyers buy more of Vandria's exports. Planned spending is higher at every price level, so AD shifts right, to the new curve AD₁. The equilibrium moves from E, at real output $600bn and a price level of 100, to E₁, at real output $640bn and a price level of 105.
Why does the price level rise as well? To produce more, firms must hire more workers and pay for extra hours of work, which often cost more per hour. Each extra unit then costs more to produce, so firms supply more only at a higher price level. This is why the AS curve slopes up once firms are using many of their workers and machines. The AS curve itself has not moved: the equilibrium moves along it, to a higher real output and a higher price level.
A fall in AD reverses each of these changes. Suppose firms in Vandria expect lower sales and invest less. Investment is an injection, so AD shifts left. The new equilibrium is at real output $560bn and a price level of 95: firms produce less and need fewer workers and fewer extra hours, so their costs per unit fall, and the price level falls with real output.
So an AD shift moves real output and the price level in the same direction. How much of the shift becomes real output, and how much a change in the price level, depends on how steep the AS curve is.
When AS shifts, real output and the price level move in opposite directions.
Firms pay for what they use to produce goods and services: wages, raw materials (such as cotton, metal or wood), energy and machines. These are their costs of production. If these costs fall, each unit (each item a firm produces) costs less to produce, so firms plan to supply more at every price level, and AS shifts right. If they rise, firms plan to supply less, and AS shifts left.
AS also shifts when productivity changes. Productivity is the output each worker produces in an hour. Better technology or skills raise it. Then the same wage pays for more units, so the cost of each unit falls. AS also shifts right when the economy's capacity grows. Capacity is the most that the economy can produce, and it grows when there are more workers, machines or factories.
Suppose the machinery that Vandria's firms import becomes cheaper. Their costs of production fall, so AS shifts right, to AS₁. The new equilibrium, E₁, is at real output $630bn and a price level of 96, compared with $600bn and 100 at E.
Why does the price level fall while real output rises? Because each unit now costs less, firms plan to supply more real output at every price level. At the old price level of 100, firms now plan to supply more than buyers plan to buy, so the price level falls. As it falls, buyers plan to buy more real output along the unchanged AD curve, until planned spending equals planned output again at E₁. So an AS shift moves real output and the price level in opposite directions.
A fall in AS reverses each of these changes. Suppose the price of oil on world markets rises. Most of Vandria's firms use oil for energy and transport, so their costs of production rise, and AS shifts left. At the old price level of 100, firms now plan to supply less than buyers plan to buy, so the price level rises. Real output falls to $570bn, and the price level rises to 104.
When only one curve shifts, the pair of directions tells you which curve it was:
Exam Matters: When data give the change in real output and in the price level, and only one curve has shifted, use the pair of directions to name that curve and say why, before you explain what caused the shift.
An injection raises national income by more than itself, because the income it creates is spent again.
Vandria's government spends an extra $40bn on a new port. Government expenditure is an injection, so $40bn of new spending enters Vandria's circular flow. Assume the price level stays the same, so every extra dollar of income is extra real output. By how much will national income rise?
The $40bn is paid to the firms building the port and to their workers, so it becomes their income. Each step in which spending becomes someone's income is called a round.
Households in Vandria spend 60 cents of each extra dollar of income on Vandria's goods and services. The other 40 cents is saved, taxed or spent on imports. The 60 cents reaches firms in Vandria and becomes income for the people who work there, so it starts the next round.
Why does national income stop at $100bn more? Because the new withdrawals of $40bn now equal the new injection of $40bn.
Before the port, national income was $600bn, and injections and withdrawals were both $240bn. At $700bn, injections are $240bn + $40bn = $280bn, and withdrawals have also risen by $40bn, to $280bn. Injections equal withdrawals again, so national income stops changing at its new equilibrium.
The number that compares the $100bn rise with the $40bn injection has a name.
Multiplier: the number of times by which a change in injections changes national income.
Put simply, the multiplier tells you how many dollars of national income each new dollar of injection creates in the end. In Vandria it is $100bn ÷ $40bn = 2.5: each extra dollar the government spends adds $2.50 to national income.
The rounds of spending that create this total are called the multiplier process.
Exam Matters: In an Explain answer, show two or three rounds with their figures and say why each round is smaller. Then give the total, and say why the rounds stop there.
How households divide each extra dollar of income decides how much of it reaches the next round.
When Vandria's government spent $40bn more on the port, the builders spent 60 cents of each extra dollar and withdrew the other 40 cents. Each of these shares is called a propensity: the share of extra income that goes one way.
Each of these propensities is marginal: it is a share of the extra dollar of income, not a share of all the income a household already has. The two can differ: a household that spends nearly all its income may save much of a pay rise. The multiplier uses the share of the extra dollar, because each round is made of new income.
Marginal propensity to consume (MPC): the proportion of an increase in income that is spent on consumption.
Put simply, MPC is the part of each extra dollar that households spend on goods and services made in their own country. To find it, divide the extra spending by the extra income. If your pay rises by $10 and you spend $6 more on goods and services made in your country, your MPC is $6 ÷ $10 = 0.6.
Why only goods and services made at home? Spending on imports becomes income in another country, not in this one, so it is counted with the other ways a dollar leaves the flow. This is why Vandria's MPC is 0.6: the 60 cents of each extra dollar spent on Vandria's goods and services.
Marginal propensity to save (MPS): the proportion of an increase in income that is saved.
Put simply, MPS is the part of each extra dollar that households save. In Vandria it is 0.1: of the 40 cents of each extra dollar that is withdrawn, households save 10 cents.
A consumed dollar reaches a firm in Vandria and becomes someone's income, so it starts the next round. A saved dollar reaches no firm in this round, so it is a withdrawal, and the process stops there for that dollar. So a larger MPC makes each round a larger share of the one before, because more of each extra dollar is spent in Vandria and less is withdrawn. A larger MPS makes each round a smaller share of the one before, because less of each extra dollar is spent in Vandria.
Tax and imports also take a share of each extra dollar, and with saving they make up all that leaves the flow.
In Vandria, 60 cents of each extra dollar is consumed and 10 cents is saved. Of the other 30 cents, part is taken in tax and part buys goods and services made abroad.
Marginal propensity to tax (MPT): the proportion of an increase in income that is taken in tax.
Put simply, MPT is the part of a pay rise that the government takes before the household can spend it. In Vandria it is 0.2: the government takes 20 cents of each extra dollar.
Marginal propensity to import (MPM): the proportion of an increase in income that is spent on imports.
Put simply, MPM is the part of each extra dollar spent on goods and services from other countries, such as a phone made abroad or a holiday abroad. In Vandria it is 0.1, and that 10 cents becomes income for firms abroad.
Saving, tax and imports have one thing in common. Each takes part of the extra dollar away before it can become income for a firm in Vandria, so each is a withdrawal. Their three propensities add up to one figure.
Marginal propensity to withdraw (MPW): the proportion of an increase in income that is withdrawn from the circular flow.
Put simply, MPW is the part of each extra dollar that does not reach the next round. Here is where an extra $100 of income goes in Vandria:
Every extra dollar goes one of these four ways, and there is nowhere else for it to go. So the four propensities add up to 1: MPC + MPS + MPT + MPM = 1. Whatever part of the dollar is not withdrawn is consumed.
This is why MPW matters for the multiplier. A larger MPW means more of each round leaves the flow, so each round is smaller and the multiplier is smaller.
The multiplier can be worked out from MPC or from MPW, and both ways give the same answer.
Vandria's government wants to know how much national income will rise before it spends the $40bn. It cannot wait for the rounds to happen and then measure them. Instead, it uses the propensities, in one of two formulae: 1/(1 − MPC) or 1/MPW.
Why does dividing 1 by MPW give the multiplier? The rounds stop when the new withdrawals equal the injection. Each extra dollar of income adds MPW of a dollar to withdrawals, so national income must rise until MPW times the rise equals the injection. The rise is therefore the injection divided by MPW: in Vandria, $40bn ÷ 0.4 = $100bn. The multiplier is that rise divided by the injection, so it is 1 ÷ MPW = 1 ÷ 0.4 = 2.5.
Why do the two formulae give the same answer? Every extra dollar is either consumed or withdrawn. So MPC and MPW add up to 1, the whole dollar. This means that 1 minus MPC is the same number as MPW. Both formulae divide 1 by that number, 0.4. Use whichever one the data gives you.
The same steps work when an injection falls. Suppose Vandria's exports fall by $20bn instead. Exporters and their workers lose $20bn of income, so they spend less in the next round, and the loss is multiplied in the same way.
The multiplier can also be measured from data after the event, using its definition: the change in national income divided by the change in injections. This route needs no propensities, only the two changes.
Exam Matters: In a Calculate answer, write the formula, put the figures from the data into it, and then give the answer.
An injection shifts AD by more than its own size: by the injection times the multiplier.
Vandria's government spends $40bn more on the port. On an AD/AS diagram, how far does the AD curve move? AD is the total planned spending on Vandria's goods and services at each price level. With a multiplier of 2.5, the $40bn leads to $100bn of extra spending in all the rounds together.
Does AD shift by the first $40bn, or by the whole $100bn? By the whole $100bn. Each round of extra spending happens at every price level, because MPC is 0.6 whatever the price level is. So at every price level, planned spending is $100bn higher, and the whole AD curve shifts right by $100bn, from AD to AD₁.
A fall in an injection works in the same way, in the opposite direction. Suppose Vandria's exports fall by $20bn. Exporters lose $20bn of income, and spending is lower in every round that follows. With a multiplier of 2.5, AD shifts left by $50bn, not by $20bn.
This matters for a government. With a multiplier of 2.5, spending $40bn moves AD 2.5 times as far as the money spent, and a cut in spending lowers AD by 2.5 times the cut.
Exam Matters: When you draw the shift, label the horizontal gap between AD and AD₁ with the injection times the multiplier, not with the injection.
How much of an AD shift becomes extra real output depends on how many workers and machines are unused.
With a multiplier of 2.5, AD in Vandria shifts right by $100bn, to a new curve, AD₁. Does real output then rise by $100bn? Only if firms can produce $100bn more. That depends on spare capacity, which means unused workers and machines that firms could put to work. When every worker and machine is already in use, the economy is at full capacity.
Why does spare capacity matter? When workers have no jobs and machines stand idle, firms can produce more without paying more for each unit. Near full capacity, few workers and few inputs (the materials and parts used in production) are still unused, so firms compete for them. Wages and other costs rise, so firms raise their prices.
With lots of spare capacity, the whole $100bn shift becomes extra real output. Firms meet the extra spending by using idle workers and machines, at the same cost per unit, so the price level stays at 100.
With some spare capacity, real output rises by only $60bn, to $660bn. Firms' costs rise as they compete for scarcer workers and inputs, so the price level rises to 110. As it rises, buyers move up along AD₁ and plan to buy less real output than the $700bn they would buy at 100. So real output ends $60bn higher, not $100bn.
At full capacity, real output cannot rise at all, because every worker and machine is already in use. The price level rises to 120, until the real output buyers plan to buy along AD₁ is back to $600bn, the most the economy can produce.
So the same multiplier can give very different results for economic activity. When Vandria has lots of spare capacity, $40bn of new spending creates $100bn of extra real output, and firms need more workers to produce it. At full capacity, the same spending creates no extra real output and no new jobs, only a higher price level.
Exam Matters: In an Examine answer, find the evidence on spare capacity in the data, and use it to judge how much of the AD shift becomes real output.
A country's multiplier is large when little of each extra dollar is withdrawn, and small when much of it is.
Vandria's government wants to pay for its $40bn of new spending by raising income tax. After the rise, the government takes 30 cents of each extra dollar of income, instead of 20 cents. So MPT rises from 0.2 to 0.3.
Why does the tax rise shrink the multiplier? In every round, 10 cents more of each extra dollar now goes to the government in tax. So less is spent again, and each round is smaller. The tax rise that pays for the spending makes the multiplier on that spending smaller.
In some countries, imports take an even larger share of each extra dollar than tax takes in Vandria. Talu is a small island economy that imports most of what its people buy. Its MPS is 0.1, its MPT is 0.1 and its MPM is 0.6.
In Talu, 60 cents of each extra dollar buys goods made abroad. Spending on imports is not extra spending in Talu: it becomes income in other countries. Only the 20 cents that is not withdrawn, 1 − 0.8, is spent again in Talu, so each round is only 0.2 of the one before, and the rounds shrink fast.
The model gives the same pattern for any country. If the other two propensities stay the same, the multiplier is larger when MPS, MPT or MPM is smaller, and smaller when one of them is larger.
For a government, this means the multiplier is an estimate (a careful guess), not a fixed number. It changes when tax rates, saving or spending on imports change. So two governments that spend the same amount can get very different rises in national income.
People earn money from businesses and spend it on what businesses make, so money moves in a circle.
The same dollars can be counted at three points on the circle, and each count gives the same total.