2.3.4 - National income

The circular flow links households and firms. Households supply factors of production and receive income; they spend on firms' output, creating revenue that funds further production and income.

For the economy, one person's spending is another's income: output, expenditure and income are alternative measures of the same production flow.

Income can be consumed or saved; saving adds to wealth. Wealth can generate income or affect consumption through confidence and collateral.

Net injection is $I+G+X-(S+T+M)$. Its sign indicates whether these flows add to or remove from the circular flow, other things equal.

An increase in an injection, with withdrawals unchanged, raises firms' revenue, output and income and can trigger a positive multiplier process.

An increase in a withdrawal, with injections unchanged, reduces domestic revenue, output and income and can trigger a negative multiplier process.

As income changes, saving, tax and imports respond, so withdrawals move until planned injections equal planned withdrawals at a new equilibrium.

Reflationary fiscal policy can raise $G$ or reduce $T$; deflationary policy can reduce $G$ or raise $T$. Trade surpluses add net export injection, while deficits create net withdrawal through trade.

Equilibrium real national output is the level of real output/income at which planned aggregate demand equals planned aggregate supply. In circular-flow terms, planned injections equal planned withdrawals.

If planned expenditure exceeds current output, inventories fall unexpectedly and firms expand production. If output exceeds planned expenditure, inventories accumulate and firms contract production.

Identify the determinant, shift the relevant curve, locate the new intersection and compare both coordinates. Consumption, investment, government expenditure and net exports shift AD; short-run costs or long-run capacity shift AS.

The size of the output response depends on spare capacity and the AS shape. With classical vertical LRAS, an AD shift changes the long-run price level but not potential output.

The multiplier is the ratio of the final change in national income to the initial autonomous injection: $k=\Delta Y/initial\ injection$.

An injection becomes income for workers and firms. They spend a fraction of that extra income, creating another person's income; each round is smaller because saving, tax and imports withdraw part of the addition. The rounds continue until the remaining additions are negligible.

A fall in autonomous spending starts the same chain in reverse, so national income can fall by more than the initial withdrawal.

In a closed simplified model, $MPC+MPS=1$. With proportional tax/import leakages, $MPW=MPS+MPT+MPM$ and a larger MPW means a smaller multiplier.

If $MPC=0.6$, then $k=1/(1-0.6)=2.5$. An initial $4$ billion injection gives a final income increase of $2.5\times4=10$ billion, ceteris paribus.

If $k=5$, then $MPW=1/5=0.2$ and, in the simplified MPC formula, $MPC=1-0.2=0.8$.

An autonomous change in $C$, $I$, $G$ or $X-M$ shifts AD initially. The multiplier process makes the eventual shift in AD and national income larger than the first spending change.

The multiplier helps estimate fiscal, investment or export shocks, but estimates vary with the cycle, distribution, openness, tax system and time horizon.