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Asked by Bagrijs | Feb 16, 2006 | A Level > Economics > Homework
Bagrijs asks:

Describe the circular flow of income and expenditure with government and an open economy. Explain what determines the equilibrium level of output, and how equilibrium would be restored if there was a rise in investment.

etutor answers:

The circular flow of income in the first instance refers to the flow of income between households and firms. Households provide firms with what are known as factor services i.e. contributions to production (labour, land, capital, entrepreneurship) and in return receive incomes (wages, rent, interest, profits). These incomes are then spent on the goods and services produced by the firms. The process therefore continues indefinitely. If nothing is ever added to the flow of income, or removed from it, then the level of income in the economy remains the same in every time period.

In practice, there are INJECTIONS INTO and WITHDRAWALS FROM the circular flow. An injection is any increase in spending that does not arise from households (consumers). In a closed economy (no foreign trade) without a government, the only injection is INVESTMENT. Investment occurs when firms spend on new capital equipment. Since this spending creates a demand for the output of capital goods industries, it increases the overall level of spending, and therefore raises the level of income. In the same economy, whenever consumers or firms do not spend all their income this is called SAVING. Since saving reduces the amount of spending in the economy, it is a withdrawal from the circular flow, and it reduces the level of income. If there is a government in the economy, then any spending by the government is an injection, while its taxation on consumers and firms reduces their spending, and is therefore a withdrawal from the circular flow. In an open economy, there is foreign trade. When the economy exports goods and services, it receives additional income, and so this is an injection. When it imports goods and services from abroad, income flows out of the economy (to foreigners), and so this is a withdrawal. Hence in an open macro-economy, the injections are investment, government spending and exports, while the withdrawals are saving, taxation and imports. If the sum of injections exceeds the sum of withdrawals then the level of income will rise; if the sum of withdrawals exceeds the sum of injections, then the level of income will fall. So the equilibrium level of output is determined by the level of spending (or aggregate demand) on the economy. AD is made up of consumer spending, investment by firms, government spending and net export revenues.

If there is an increase in any component of AD, such as investment by firms, then in the first instance this will create new income for the capital goods industries equal to the increase in investment spending, Suppliers and workers will then spend some of this income on consumer goods and services, while the remainder of the extra income is leaked out of the circular flow in the form of savings, tax revenue and spending on imports. The increased consumer spending now provides additional income for another group of people, who in turn spend a proprtion of it, with the remainder leaked out of the system as before. This process of successive rounds of income generation continues until the additional income produced is statistically zero. What we have here is called the multiplier process. The value of the multiplier is calculated by dividing 1 by (1 minus the marginal propensity to consume). The mpc is the proportion of additional income that is spent at each stage. So, for example, if the mpc were 0.8, then four fifths of the increase in income is spent. Hence, applying the formula, the value of the multiplier is 5. So if the initial increase in investment were, say, 2000, then this will lead to a final increase in income of 10000, made up of an additional 8000 in consumer pending, and an additional 2000 in savings/taxation/imports. Note that the increase in leakages is exactly equal to the original increase in injections (investment). Hence income is again in equilibrium, with injections equal to leakages. This means there is no tendency for income to change - until there is another change in injections which will then set off the multiplier process again, in exactly the same way.

I hope this is helpful.

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