National income and the circular flow
Key terms
Define each term.
Multiple choice
Circle the correct answer.
In a four-sector circular flow, national income is in equilibrium when:
A country hosts extensive foreign-owned manufacturing. Which is most likely?
Worked problems
Show your working.
Stripping inflation out with the GDP deflator. A country's nominal GDP is $600 billion. The GDP deflator stands at 125, with the base year set at 100. Calculate real GDP at base year prices. Then explain what it would mean if nominal GDP rose to $660 billion the following year while the deflator rose to 137.5.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How an injection raises national income by more than itself
- A Firms increase investment spending, which is an injection into the circular flow.
- B The rounds form a converging series, so the total increase in national income is finite but larger than the original injection.
- C Those households spend a proportion of the extra income on domestic goods and services.
- D Each round is smaller than the last, because a share of income leaks out as saving, taxation and imports at every stage.
- E That spending becomes income for a further set of households, who spend a proportion of it in turn.
- F The economy settles at a new equilibrium where withdrawals have risen enough to match the higher injections.
- G The firms supplying the machinery receive that spending as revenue, and it becomes income for their workers and owners.
Diagrams
Draw a circular flow diagram with households and firms. Show the income flow and the expenditure flow between them. Then add the three withdrawals (saving, taxation, imports) leaving the flow and the three injections (investment, government spending, exports) entering it, labelling each with the sector it passes through: the financial sector, the government and the foreign sector.
Answers
Gross domestic product: The total value of all final goods and services produced within a country's borders in a given period.
B. Equilibrium requires the totals to match, not each individual pair. A country can run a trade deficit offset by a budget deficit or by investment exceeding saving. Equilibrium also says nothing about unemployment: an economy can be in equilibrium well below full employment, which is the central Keynesian claim.
B. The output is produced inside the borders so it counts in GDP, but the profit flows to owners abroad so it does not count in the income of residents. Net primary income from abroad is negative, making GNI lower than GDP. This gap is one reason GDP can overstate the material position of a host country's residents.
Step 1. Apply the deflator relationship. Real GDP = (nominal GDP / deflator) x 100 = (600 / 125) x 100 = $480 billion.
Step 2. Interpret the first figure. Prices are 25% higher than in the base year. At base year prices the same output would be worth $480 billion, so $120 billion of the headline figure is price increase rather than production.
Step 3. Calculate real GDP for the second year. Real GDP = (660 / 137.5) x 100 = $480 billion.
Step 4. Compare and interpret. Nominal GDP rose by 10%, from 600 to 660. Real GDP is unchanged at $480 billion. The deflator also rose by 10%, from 125 to 137.5, so the entire increase was inflation. The economy produced exactly the same quantity of goods and services in both years despite the headline figure rising by a tenth.
Step 5. State the general rule. Real growth is positive only when nominal growth exceeds the rise in the deflator. Comparing nominal figures across years, or between countries with different inflation rates, tells you nothing about output.
The GDP deflator differs from the consumer price index in an examinable way: the deflator covers everything produced domestically, including investment and government output, while CPI covers only a basket of consumer goods and includes imports. They can move differently and questions sometimes turn on that.
A, G, C, E, D, B, F
- Firms increase investment spending, which is an injection into the circular flow.
- The firms supplying the machinery receive that spending as revenue, and it becomes income for their workers and owners.
- Those households spend a proportion of the extra income on domestic goods and services.
- That spending becomes income for a further set of households, who spend a proportion of it in turn.
- Each round is smaller than the last, because a share of income leaks out as saving, taxation and imports at every stage.
- The rounds form a converging series, so the total increase in national income is finite but larger than the original injection.
- The economy settles at a new equilibrium where withdrawals have risen enough to match the higher injections.
The last step is the one worth understanding rather than memorising. The multiplier process stops precisely when the extra withdrawals generated by the higher income equal the original injection, which is why the size of the multiplier is determined by the marginal propensity to withdraw. The arithmetic is worked through in the fiscal policy note.
Pair each withdrawal with the injection that returns through the same sector: saving with investment through the financial sector, taxation with government spending, imports with exports. Equilibrium requires the totals to match, not each pair individually, and questions often turn on that distinction. A country can run a trade deficit indefinitely provided the shortfall is offset elsewhere in the flow.