Equilibrium and change in the circular flow

Overview

National income when injections exceed withdrawals.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What happens to national income when injections exceed withdrawals, and why does the process not continue indefinitely?

   Model answer

   More spending enters the flow than leaves it, so firms find their output selling and expand production, hiring more factors and paying out more income; national income rises. As income rises, households save more, pay more tax and buy more imports, so withdrawals rise too. Income keeps expanding until the higher withdrawals have risen to match the injections, at which point a new, higher equilibrium is reached.

2. 2

   An economy has withdrawals of 1,280 billion pounds and injections of 1,240 billion pounds. State whether national income will rise or fall, and by how much the two totals differ.

   Model answer

   Withdrawals exceed injections by 1,280 minus 1,240, which is 40 billion pounds. More purchasing power is leaving the flow than entering it, so spending on domestic output falls short of the income paid out. Firms will find stocks building up, cut production, and national income will fall until withdrawals have shrunk back to the level of injections.

3. 3

   Starting from injections of 1,240 billion pounds and withdrawals of 1,280 billion pounds, exports then rise by 60 billion pounds. Calculate the new imbalance and state its effect.

   Model answer

   New injections are 1,240 + 60 = 1,300 billion pounds, while withdrawals are unchanged at 1,280 billion pounds. Injections now exceed withdrawals by 20 billion pounds. The flow of income will expand, and it will keep expanding until the extra saving, taxation and import spending generated by the higher income close the 20 billion pound gap.

4. 4

   Why is equilibrium in the circular flow not the same thing as full employment?

   Model answer

   Equilibrium only requires that the money leaving the flow equals the money entering it, which can happen at any level of income. If injections are weak, the flow can settle at a level of output that uses far fewer resources than the economy possesses, leaving labour and capital idle. Nothing in the equilibrium condition guarantees that the resulting level of output is the one that fully employs the workforce.

5. 5

   The savings ratio in an economy rises from 8 per cent to 10 per cent of a household disposable income of 1,500 billion pounds. Calculate the change in withdrawals and analyse the effect on the flow.

   Model answer

   Saving was 0.08 × 1,500 = 120 billion pounds and becomes 0.10 × 1,500 = 150 billion pounds, so withdrawals rise by 30 billion pounds. Consumption falls by the same amount, so firms sell less, cut output and lay off factors, and income falls. As income falls, saving, taxation and imports all decline, so the flow contracts until withdrawals have fallen back to the level of injections at a lower national income.

6. 6

   Analyse the effect on the circular flow of a rise in the rate of income tax, other things being equal.

   Model answer

   A higher income tax rate increases the taxation withdrawal at any given level of income and reduces disposable income, so consumption spending on domestic output falls. With withdrawals now exceeding injections, firms' revenues fall short of the incomes they have paid out, so they reduce production and employment and national income contracts. The contraction continues until the falling income has reduced saving, tax receipts and import spending enough to restore equality with injections, leaving the economy at a lower equilibrium level.

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