The circular flow and aggregate demand
The economy is a web of spending and income. The circular flow model and the idea of aggregate demand show how it fits together.
The circular flow
In the simplest circular flow, households sell labour and other resources to firms in exchange for income, and spend that income buying firms' goods and services. Money flows one way; goods and resources flow the other. Spending by one group is income for another.
Leakages and injections
Not all income is spent on domestic output. Leakages are saving, taxes, and imports. Injections are investment, government spending, and exports. When injections equal leakages, the flow of national income is stable; if injections exceed leakages, income grows, and if leakages exceed injections, income shrinks.
Saving and investment
In a closed economy, national saving (private saving plus government saving) equals investment. Financial markets channel saving to borrowers who invest. If the government runs a deficit, it reduces national saving, which can push up interest rates and reduce private investment, called crowding out.
Aggregate demand
Aggregate demand (AD) is the total demand for an economy's output at each price level: C + I + G + NX. The AD curve slopes downward: at a higher price level, real wealth falls, interest rates tend to rise, and exports become less competitive, so real spending falls.
Shifts in aggregate demand
AD shifts with changes in consumer confidence and wealth (rising house prices boost spending), business expectations and interest rates (affecting investment), government spending and taxes, foreign incomes and exchange rates (affecting net exports), and the money supply.
The multiplier
An initial increase in spending raises income, which leads to more spending, and so on. The total increase in GDP is a multiple of the initial change. With a marginal propensity to consume (MPC) of 0.8, the simple multiplier is \(\frac{1}{1 - 0.8} = 5\). Real-world multipliers are smaller, because of taxes, imports, and other leakages.
Worked example
The government spends an extra 10 billion dollars on roads. Construction workers spend 80% of their extra income, 8 billion; the recipients spend 80% of that, 6.4 billion; and so on. The total rise in spending is 10 / (1 - 0.8) = 50 billion in this simple model. Realistic estimates for such multipliers are often between about 0.5 and 2.
National accounts in practice
Statistical agencies such as the US Bureau of Economic Analysis publish GDP estimates quarterly, revising them as more data arrive. Early estimates can change noticeably, which complicates policy decisions made in real time.
Key takeaways
In the circular flow, spending becomes income. Leakages (saving, taxes, imports) and injections (investment, government spending, exports) determine whether income grows. National saving equals investment in a closed economy; deficits can crowd out investment. Aggregate demand is C + I + G + NX and slopes down. The multiplier is 1/(1 - MPC) in the simplest model; real multipliers are smaller.
Flashcard
Spending by one group is income for another
Check your understanding
If the marginal propensity to consume is 0.75, what is the simple spending multiplier?