9.1 The circular flow of income

The multiplier is the ratio of the final change in national income to the initial change in autonomous spending. Each round of extra income creates further spending, but leakages through saving, taxation and imports limit the total.

In a simple model, a higher marginal propensity to consume produces a larger multiplier. The actual effect also depends on spare capacity, prices, interest rates, supply and whether spending crowds out other demand.

If the marginal propensity to consume is 0.75 and the simple closed-economy multiplier is 1/(1−0.75)=4, an initial $10 increase in investment could raise equilibrium income by up to$40 in the stylised model.

The multiplier is not an automatic promise that GDP rises by the textbook number; assumptions and supply constraints matter.

Aggregate demand (AD) is total planned expenditure on domestically produced final goods and services: AD = C + I + G + (X − M). Consumption, investment, government spending and net exports are its components.

Each component has its own determinants: income and confidence affect consumption, interest rates and expectations affect investment, policy affects government spending, and foreign income, prices and exchange rates affect exports and imports.

If C=500, I=120, G=180, X=90 and M=110, AD is 780. Imports are subtracted because they are spending on foreign output.

AD is a flow of planned spending, not the same as GDP in every disequilibrium period, and imports are not added just because they are purchases.

National income is the income generated by production in an economy. In principle, the output, expenditure and income approaches give the same total because one person’s spending is another’s income and output is the corresponding product.

In practice, inventories, informal activity, timing, valuation, depreciation and statistical error create gaps. GDP measures domestic production; GNI adjusts for net factor income from abroad, so the distinction matters for economies with large cross-border income flows.

A firm’s sale is expenditure for the buyer, revenue and factor income for workers and owners, and part of measured output. If stock is produced but unsold, inventory investment prevents the output from disappearing from the expenditure measure.

The accounting identity does not mean every household’s income equals its consumption, and measured national income is not a complete welfare index.