National Income

National income is the total value of output produced by an economy over a period of time, usually a year (1). It can be measured in three equivalent ways because income = output = expenditure (1).

An injection is spending added to the circular flow that does not come from households' current income. One example is government spending (G) — for instance, the state building a new hospital (1); this adds money to the flow and tends to raise national income (1).

A withdrawal (leakage) is income taken out of the flow rather than spent on domestic output. One example is saving (S) — income households keep rather than spend (1); this removes money from the flow and tends to lower national income (1).

Investment (I) — firms' spending on capital goods such as machinery and factories — is an injection into the circular flow of income, because it adds spending that does not come from households' current income.

Starting from equilibrium national income, where total injections equal total withdrawals (I + G + X = S + T + M), a rise in investment means injections now exceed withdrawals. More money is being added to the flow than is leaking out of it, so total spending in the economy rises.

Firms respond to this higher demand by producing more output. To do so they hire more factors of production — more labour, more capital — and pay out more factor incomes (wages, rent, interest, profit) to households. Households in turn spend part of this extra income on firms' output, generating a further round of spending and income.

As a result, national income rises, and the circular flow expands. It keeps growing until withdrawals rise back up (households save and are taxed more, and buy more imports, as their income grows) to match the higher level of injections, settling at a new, higher equilibrium national income. So an increase in the injection of investment raises the level of national income, output and employment.

Saving (S) is a withdrawal (leakage) from the circular flow of income: it is income that households receive but do not pass straight back to domestic firms as spending.

The direct effect. Starting from equilibrium (injections = withdrawals), a rise in saving means households spend a smaller share of their income on goods and services, so consumption falls. Withdrawals now exceed injections: more money is leaking out of the flow than is being added. Firms face lower demand, so they cut output and reduce the factors they hire, paying out less income. National income therefore falls, and the flow contracts until injections and withdrawals are back in balance at a lower equilibrium national income — with lower output and higher unemployment in the short run.

A second effect — saving funds investment. However, saving is not money 'lost' from the economy. The extra saving flows into banks, which lend it out; this can fund higher investment (an injection). If firms borrow and invest the extra saving, the injection of investment offsets the withdrawal of saving, and the fall in national income is limited — or, over time, higher investment raises the economy's productive capacity.

On balance, a rise in saving tends to reduce national income in the short run by cutting current spending, but the effect depends on whether the saving is channelled back into the flow as investment.

Government spending (G) — on public services and infrastructure — is an injection into the circular flow of income. A large increase in G adds spending to the flow that does not come from households' current income.

The main effect. Starting from equilibrium national income (I + G + X = S + T + M), a rise in G means injections now exceed withdrawals, so more money enters the flow than leaks out. Total spending rises; firms respond by producing more output, hiring more factors and paying out more factor incomes. Households spend part of that extra income, triggering further rounds of spending. National income therefore rises, expanding until withdrawals rise back to match injections at a new, higher equilibrium. Because the extra spending is re-spent round the flow, the final rise in national income is likely to be larger than the initial injection — the multiplier effect — and it tends to raise output and employment.

Evaluation — how large is the effect? The size and desirability of the effect are uncertain, for several reasons.

First, it depends on the state of the economy. If there is spare capacity (unemployed workers and idle factories), higher G can raise real output with little inflation. But if the economy is near full capacity, the extra demand mainly raises the price level, causing inflation rather than more output.

Second, it depends on the size of withdrawals. If households save a large share, or spend much of the extra income on imports, the money leaks out of the domestic flow quickly, so the multiplier is small and the rise in national income is limited.

Third, it depends on how the spending is financed. If the government raises taxes (a withdrawal) or borrows to pay for it, part of the injection is offset, and higher borrowing may raise interest rates and 'crowd out' private investment.

Judgement. A large rise in government spending will most likely increase national income, output and employment, because it injects spending that circulates through the flow. But the magnitude depends on whether there is spare capacity, the size of leakages, and how the spending is financed. The policy is therefore best judged in context: it is a powerful way to raise national income in a slump, but risks mainly inflation if the economy is already at full capacity.

National income is the total value of output produced in an economy over a period, measurable three equivalent ways: income = output = expenditure. Its level depends on the balance in the circular flow of income between injections (Investment I, Government spending G, eXports X) and withdrawals (Saving S, Taxation T, iMports M). At equilibrium national income, injections equal withdrawals and the flow is stable. The question is whether a rise in injections will always raise national income.

The case that a rise in injections raises national income. When any injection rises from an equilibrium position, injections exceed withdrawals, so more money enters the flow than leaks out. Total spending rises, firms produce more, hire more factors and pay out more factor incomes; households re-spend part of that income, generating further rounds. Through the multiplier, the final rise in national income can be larger than the initial injection, expanding the flow to a new, higher equilibrium with more output and employment. On this reasoning, a rise in investment, government spending or exports increases national income.

The case that it will not always do so. First, the effect depends on spare capacity. If the economy is at or near full employment, there are no idle factors to bring into use, so higher injections mainly raise the price level (inflation), leaving real national income little changed — and it is real income that reflects living standards. Second, it depends on the size of withdrawals: if the extra income is quickly saved, taxed or spent on imports, the money leaks out of the domestic flow, the multiplier is small, and the rise in national income is modest. Third, injections may be offset: government spending financed by higher taxes or borrowing can crowd out private spending, and an export rise driven by a weaker currency may be matched by dearer imported inputs. Finally, whether real national income rises at all depends on separating the genuine rise in output from a purely nominal (inflationary) rise.

Evaluation and judgement. Whether a rise in injections always raises national income depends on the context. Starting from a position with spare capacity, and where leakages are small, a rise in injections will raise real national income substantially, amplified by the multiplier — so in a slump the statement holds well. But near full capacity, or where withdrawals are large or the injection is offset by financing effects, the rise may show up mainly as inflation (higher nominal but flat real income) rather than extra output. The most defensible conclusion is therefore that a rise in injections will tend to increase national income, but not always, and not always in real terms: the outcome depends on the amount of spare capacity, the size of leakages, and how the injection is financed. The word 'always' is too strong.