The circular flow of income

Summary

The circular flow of income illustrates how money moves through an economy, involving households, firms, government, and foreign sectors. It explains concepts like the multiplier, which shows how initial spending changes lead to a larger increase in GDP, and the accelerator, which describes how investment is influenced by changes in income.

• Multiplier — shows the relationship between initial spending changes and the final increase in GDP.
  Example: A $20 billion increase in government spending leading to a$100 billion rise in GDP results in a multiplier of 5.
• Marginal Propensity to Consume (MPC) — the proportion of extra income that is spent.
  Example: If a person receives an extra £100 and spends £70, the MPC is 0.7.
• Marginal Propensity to Save (MPS) — the proportion of extra income that is saved.
  Example: If a person receives an extra £100 and saves £30, the MPS is 0.3.
• Marginal Rate of Tax (MRT) — the proportion of extra income that is paid in tax.
  Example: If an extra £100 of income results in £20 of tax, the MRT is 0.2.
• Accelerator — theory that investment is influenced by the rate of changes in income.
  Example: A $1 million rise in GDP resulting in a$3 million increase in investment with an accelerator coefficient of 3.

Exam Tips

Key Definitions to Remember

• Multiplier
• Marginal Propensity to Consume (MPC)
• Marginal Propensity to Save (MPS)
• Marginal Rate of Tax (MRT)
• Accelerator

Common Confusions

• Confusing the multiplier with the accelerator
• Misunderstanding the relationship between MPC and MPS

Typical Exam Questions

• What is the multiplier?
  It shows the relationship between initial spending changes and the final increase in GDP.
• How does the accelerator theory affect investment?
  It suggests that changes in the growth of income influence investment.
• When does an economy experience an inflationary gap?
  When total expenditure is greater than the full employment level of GDP.

What Examiners Usually Test

• Understanding of how the multiplier and accelerator affect the economy
• Ability to calculate and interpret MPC, MPS, and MRT
• Explanation of the circular flow of income and its components