A Level.

Economics (Essays) T i
_ _ _ _ _ __:__ __:_..:__ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Op C 3,2
Question 1
sume out of national incon-. T . 1111911 i
b r • , ..e. his
It is feared that if the government increases taxes y a swmg downwards in th can be sh
the level of national income will fall. Explain, .- . ti CI e consu111 . ol\'ii
tt~n rom to ~ 2. If we now add Pt1on !'tin
whether this is necessarily true. [10] ment arid government spendin Planned inv c.
aggregate expen d1ture. lines in tig, we arr·1Ve at est.,L
[J08/P4/Q6(a)] .m tax rates has led to a fall in a1gure ab 0ve. I\ ri"1e
ture tirom E.1 to E2 and as a conseggregate expendi.se
Essay l'b . . I. quence th
1 num na!tona income falls from y toy eequj.
1
However, the final effect on natio • 2•
National income is the value of the flow of goods . na
only be estimated by considering th inco
1
h me can
and services becoming available to a nation during
t e com 1.e corresponding changes i er sideof
h . . . e ot
a given period. Governments can influence the . n governm
expend1ture. !1 .increase m tax rates With no ent
A . .
flow ofnational income by altering their policy re-
lated to expenditure and levying of taxati?n. sponding change in government e COrre-
would result tn . a fall m . national incomXpendit Ure
Tax is a legal compulsion and results in a transfer e. 8ut What
1'f government increases
· both taxes and ex .
of money from individ_uals and businesses to gov- by t he same amount?
, The outcome of'tPend1ture
ernment, therefore, represent a leakage. An impor- d 'ffi
1 ~rent. For. instance,
.
1'f ma,iority
. oftaxpayI canfu be
tant classification of taxes is direct taxes such as . . ., ers hnd
the extra taxes by reducing their savings
income tax and indirect taxes such as VAT, Excise . rat er
duty etc. than consumption and government spends m
. oney
on projects related to welfare of people such
A change in direct tax rates changes the relation- housing, national income is likely to rise due to thas
ship between disposable income and national in-
redistribution of income from taxpayers to the u
come. As a result, the relationship between derprivileged. n
planned ~onsumption and national income also
changes i.e. for any given level of income there will _Si'milarly, the effect of rise in tax depends on whom
be a different level of disposable income and thus the increase in tax is levied for instance, raising
a different level of consumption and investment. taxes on higher incomes will lead. to. a small de-
A rise i~ direct tax rates with no corresponding crease in, ~onsun:ipti_on du,e t? lo"'.er MPC_and l\lfger
change m government expenditures causes a de- decrease m savings. Thus .an increase jn tax rate
crease in both disposable income and consumption would ~esult in relatively smaller fall in aggregate
expenditure at each level of national income. This expenditure and hence, a smaller fall in NY. On the
results in pivotal downward shift of the aggregate contra_ry, when increase in tax applies more on
expenditure, and thus decreases the level of na- ! 0
wer income group then, due to their higher MPC,
tional income equilibrium. · it would lead to a larger fall both in consumption
and national income
planned Raising indire t t .
expenditure when tax rate c axes · are also likely · to reduce
. AE .
.
price -ela r · s are increased
· on goods with ·high
·. s icity of demand. On the contrary in-
crease m taxe . . '. .
of d nd s on goods with low pnce elast1c1ty
spened~a mg and Willredresult· in an increa~e in consumer
creas • . uction in savings! Hence an in-
.,. (l,UJ taxation would I d . .
•ernment
. revenue · ·and 'f ea h' to an .increase m , gov-
public exp d' • 1 t ts were used to finance
en tture ther . h I.
0
Y2 Y, National income crease in natio 1• ' e ~1g t. be an overal m-
.
. 1ffs rate as pa . na Income S ·1 I . .
· 1m1 ar y, mcreasmg tar·
It is now possible to see what happens if the gov- switch expend~ of protectionist policy can help
ernment increases rates of tax so that more tax is an increase 1·n A r,reand
onNYlocal products
paid at every level of income. As shown in the fig- , _, , resulting in '
T,I:ius, we ~onc~ude th. - . -
ure above, an increase in the marginal propensity
essan·1 Y Iead to' a fail atin rais1·n
. g taxes does not nee-
to tax will lower the marginal propensity to con-
the effects of raJsing tanational income, Overall,
number of factors a Xes on NY depend on a
s explained in the answer.

,1
I I ecoflOmies (Ess_a_ys_)_ _ _ _ _ _ _ _ _ _ _ _ _ _ Topic 3.2 0 page 3
~,\le
---------
aueS11·on 1 tors influencing the level of invest-
&.
MEC&
·11 the
iac . [IO] Rate of interest
(s) 6~P1~ all economy. . r,
J11ent 11 . . . •
ent to which nat10na1mcome ts , I : L

. uss theext . [15] I .

Mp,sc . d by private investment.
.---------1----
I
dete('llllOe , [N08/P4/Q7] 1
I
I
I
,. MEC
I
I

0 k, k, stock of capital
EJS/1)': .
t ent is an important component of national
(a) ~nves me It can be undertaken by either the private By investing, a ~rm can build up a stock of capital
incom • . goods and, as with labour, capital is subject to the
the public sectors, and can mvolve the purchase
0
~new plant and machinery, the building of new law of diminishing returns so the MEC will fall. So
~ouses, factories or schools an~ ~he construction long as the MEC is greater than the rate of inter-
of roads and reservoirs. Net add1t10ns to stocks of est, the investment is worthwhile. In figure above,
raw materials, semi-finished and finished goods are investment should cease once k 1 is reached at an
also classed as investment: Note that investment interest rate r 1• A fall in. the rate of interest to r2 wi 11
is not the buying and ·selling of stocks and shares lead to a rise in the capital stock from k1 to k2• The
or the placing of money in·a bank account. increase in capital stock, k2 - k1, will require new
Jt is important to distinguish between net invest- investment to take place. The size of the capital
ment and replacement investment. The former in- stock, therefore, varies with the rate of interest.
creases capital stock and the latter simply maintains
In our explanatio·n above, the rate of interest was
capital stock. The two together constitute gross
assumed to be the rate at which firms have to bor-
investment row money. However, a large part of investment by
The decision taken by private firms to invest is firms is financed from retained profit. This does not
,likely to.be based on different criteria to those of alter the relationship between the rate of interest
the public sector. Profit is an important.factor in and investment. Thus, the higher the rate of inter-
private sector investment, whereas public sector est on savings, the higher the opportunity cost of
investment can be a political or social decision. inrestment and henc;e the lower will be the amount
When a private firm purchases a new machine, the of planner:! investment_in the economy. .
expectation js that the yield from the .investment
-Alt~ou~h rate of interest is th_e main factor, influ-
will pe greatt;r than the c;ost of b~ying machine.
encqig mvesfment but sever.al other• factors can
The expected yield i~ difficult tQ calculate since it
also lead to a change in investment. The ~ther fac-
will occur over a number of years. Also, a given
tors inc~ud~ th e. fin.n's expectations of th; future
sum of money received next year will be worth less
~conom1c chmate, and business confidence mostly
than the same sum received now. Therefore, it is
influenced _by a change in. technology, a change in
usual to ,discount these yields to , their present
value and to express the return over the initial cost - . ·' of capital
,cost · •-' a change m · government or its poli-
cies, and,. more import~ntly
. .,. the ru mors of an m- .
as a rate. This rate will be referred to as the mar-
creas~ m the .ra~e of interest.
ginal effipiency capital (MEC). Thus if~he MEC is
greater than the real rate of interest the u:iveS tment In. the preceding ana Iys1s • ,we assumed th~! invest-
should prec~de. '(he ·relationship between MEC ment .h was autonomou s. ·Th'is is·
. an -assumption
w hic we now relax .h. ,
and rate of interest is illustrated in the figure be- induced Th' , wit mvestment being partly
· is means th t ·
low. national income. a mvestment is related to
For instance when ··
this can hav: an ffi consumer demand incrc:ases,
change of natione I ect
. on . inves tment. The rate of
changes in the 1 a income will th us bring
. about
.
what 1s called th eve 1 of net ·
investment through
e accelerator principle.
 A ·Lovor EtiOhoffllcs (S•••Y•)
--~
lopic 3
.i
(b) Netlo11ttl itt~on1e i~ the value of the flow of goods
and !lervlces becomlng avalhtble to a nation during
ward when consumers
1
~,Q,
poss1"bl e price
. level or shP'ftan to buy rn 4
a given period. The equilibrium level of national I . . I s dow ore aI
sumers p an to buy less at nward \1/n each
lneome (NY) Is where planned aggregate expendi-
ture (AE) equal total output or real national income.
as depicted in the figure a~ach Possible
. . ove.
p/n c•
iec I01
The term AE denotes the total spending on goods S1m1larly a decline in the ev,1
d d . , amount Of
and services produced in an economy. It consists goo s es1red by the firrns h'ft new
of four elements: ward whereas, an increase, in s •ths AE curve cap1~1
d
o_ .
f investment goods will- shift ed~·
h ired aill
Consumer spending (C) d b. . "t e Ac ou,,
Investment expenditure (I) war_ ~b _rmg1 ng about a corresponding churve Up.
1
equ1 1 rium 1eve! of NY. The level c ange in
government spending (G) vestment changes due to change . O Planned in.
Net expenditure on exports and imports b . fid , s In Inter
usmess con ence, government Policy edst late,
(X-M), nology. an tech.
and Is usually represented by means of the follow- Also an increa,se in gove;nment p h
ing exptessioh: AE = C + I + G + (x - m) . at each price level w'fl
goo ds an d services Ure ,ases 0f
.
AE as Iong as tax collections and interestI Jncreas
e
Determination of national income equilibrium can
be illustrated through simple Keynesian analysis not ch~nge. In contrai;t, a reduction in gov
. _ -~
ernment
and is shown as follows spendmg, ,such as a _cut back i.n order for milita
hardware, will reduce AE. ry
expenditure
Y=E The .final determinant of AE is net export spending,
AEI
When foreign consumers increase their purchases
AE=C+I+(Hx-m
of the nation's commodities, the-nation's AE curve
AE2
shifts upward also a fall in imports implies an in-
: crease in expenditure on domestic expenditure. The
factors, which alter net exports, are.primarily na-
. tional _income .abroad and exchange rates.
Hence it can be concluded that private ipvestment
is not the only determinant of NY however it can
real national · be.argued that in today's.modern economies private
income
J nvestment-·has an essentially significant role play
In the graph above all points along the 45* line are in determining NY
1
equidistant.from both axes 'therefore they represent
expenditure exactly equal to income(Y=E). The AE Another important aspect of our analysis is that an
function intersects the 45* line at point 'e'. Thus increase in' AE increases equilibriu·m national in-
we have OYequilibrium level of real NY and there come by a multiple-of the initial increase in planned
would be no further tendency for NY. to change. expenditure through what ·is known as multiplier
, Hence the equilibrium level of national income oc- effect. We define multiplier as the 'ratio of the
curs where AE equals total output. - change in NY to the ·change in AE. The extent of
change in NY can be measured·by the following:
Any changes in equilibrium level ofNY are the re-
sult of changes in planned expenditure (AE). For K_ change-in-NY I
instance a rise in the amount of AE at each level of change in injection or ,K = MPS+MPT +MPM
NY will increase equilibrium level of NY and a fall
in AE will, lower equilibrium national income as •To elaborate we assume that the ec;nomy is open
shown in the graph above. with ·government sector and there are u.r.employed
resources. The MPS, MPT and MPM are OJ, O.l
Changes in planned expenditure are the conse- and 0 . 1 respectively and that the firms increase
uences of changes in all or any of the compo- th
q t of plarrned expenditure.
. eir level of planned investment by$ I 00 million.
.For mstance,
. 1"fd o- By applying the formula we can calculate the value
s h. h
.
mes tICCO nsumers collectively alter t e1r]Jurc
. ases of K in this economy and then the resulting
0 fthe nation's real output at each level ofmcome,
change in NY,
. AE curve shifts. Factors such as changes
the entire • • 2.5 = l .
wealth future expectations, mter- 0.3 + 0.1 + o. 1 •
hence, effect on NY is 2.5 times
in real con~uc~:;it avail~bility may alter co_nsumer
est rat_e an d expenditure curve shifts up- of change in investment i.e. $ I X _ = _
spendmg. Planne 00 2 5 250

fi
 Topic 3.2 t;) pago 8
,n/oS (l•••Y•)
,1 ecano -- - . ... Question J
. h multlpller effeot? The answer A World Ban:k-:-re-p-ort--:i-n-20-o-c_ _ _-- ~·- ~· ·
\\'hat cau~ei ta; lrt lnJectiol1 Into the economy 7
tinuing need for major spendinogm;enldte~don the_ con•
so~at snY Jncre m•of new incomes through ad- t t or wi e on lhfra
4 str
1•111 p;oduce d eaFor example, if firms to lnves.t s rue ure on everything from roads d ,1 •
w I 1pen 1ng, · · I .b ' · I d water and electricity generation. an rai ways to
ditlona Ill lead to more peop e eing emp oye
re, thl! w Incomes being paid to households.
.Explain the
. effect . national income when th ere 1s
d' on . an
&Jld hence tn°7' then spend part of this Increased
1110

ti°:
»ouseholdB 1estlcallY produced goods (the re-
1ncottte on withdrawn). This increased con-
increase m spen 111g on infrastructure. [lO]
{J09/P4/Q7(a)J

111alnder ww'll encourage firms to produce more

11

suniPtl~n e~t the demand, Firms will thus employ

aoods 10 mle artd other factors of production, This Essay
111°: ~eo~ven rnore incomes being paid out to (a) An increase in spending on infrastructure will act
lea 5hold· consumption will thus increase yet as a rise in injections into the circular flow of na-
house o 9• the process continues.
'n and . tional income. However, this increase in injections
aga1 , 90 , , •
, ce multiplier is not infinite, therefore, an in- is expected to have a more extensive effect upon
in In Injections wou Id not cause nattona
Scease . l .in- total economic activity. Strictly in economic terms,
~me to go on risipg forever. Each time people re- the resulting increase in national income is likely
ceive extra income they will save some of it, pay to be more than the rise in injections through what
some of It in taXeS and spend some of it on imports. is known as the multiplier effect.
Eventually, as income goes on rising, all the extra The theory of multiplier is all important in .eco-
Injections 'will have leaked away into the three nomic analysis for it shows how a change in injec-
withdrawals. At that point the multiplier process tions or leakages will influence national income.
will have ceased; a new equilibrium Y2 will have This can be described as the ratio of a change in
been reached, equilibrium national income to the change in injec-
In our analysis of simple Keynesian theory we are ti'ons. Usually denoted by "K" and stated as fol-
assuming that prices are constant Lei there is no lows; ·
Inflation and hence any increase in income is K = L\NY
matched by extra· production. So, it i's the extra M
output that this spending generates that 'we are
concerned with. However, the extent to which rise or by rearranging our equation, we can say that;
in Investment causes a change in real NY depends ANY=K X M
on the level of employment in the economy. For So, for inS tance, if $5 billion increase in spending
instance,.if the economy is already operating at full led to a $10 billion rise inNY then the size.of K =2.
employment and no. extra1resources available to The rationale und erlying the multiplier effect is that
produce output ,to match with the rising demand the ~conomy has continuous flows .of expenditure
~or,poth capital·goods and consumer goods then a~~dmco ~e through which money spent by an in-
,increase in AE results in an increase in price-level . d1v1. ua11s receive · d as income by another It c.ol- 1
alone with no change in real NY. Also the multiplier 1owsd'that an 1~1t1a
· · · I change in spending will'cause· •a
effect becom.es weaker with an increase in the ris-
~::i: i~~ch:m reaction which, although of dimin-
ing values of mps, mpt and mpm ..
Finally it can be·stated that private investment, al- io
cumu1ate ;ancl~ alt each successive step, will
mu tip e change in NY
though very important, is one ofthe four major To
de~crminants of national incoi:ne and also the ex- example f e mu It1pher
illustrate th · • process
- ·· consider an
let's
tent to ~hich changes in pr~vate inves\ment affects Furtherm 0 an open eco nomy with · government.
NY is ,ubject \9 certain con~itions ..
ore
resources in th we assume th a t ere are.unemployed
t h ,
to save is o2 e country
. and ·
marginal propensity
'l
mru-ginal pr'o' ma~gmal_ propensity to t.a,c is 0.2 and
. · prop
marginal ~ens1ty. to 1mpo rt IS• 0.1. It follows that
,l J r MPW is th ens1ty to withdraw (MPW) = 0 5
e proporti f • ··
# 1
1
withdrawn fr~m th o~ an increase in NY that is
MPS + MPT + MP~c1rc~lar flow. Where MPW =
I J $100 increase• . · This means that out of every
m mcome $50 are withdrawn
I i I'
in the
~t

.; 'y I I .
 -.
~~~===~=.:....,_:_____________
A Level Ee-0nomics (Essays) ' TOpie: 3,~ (;) ,\I
fonn of saving, taxes and imports from the circular An irtcreasedn spending . ~-8,
flow of NY and the remaining $50 are s~ent on lo- the level of injections fro: ;~:;structure 11-·11 !
cal products. Hence marginal propensity to con- move from point a to point b N i: Equilib _1
rises from Ye to Ye 1, Then.. · . a:1ona1 in nulli~ill
sume (MPCd) = 0.5. · •11 U1t1pher • Coillc,L
· increas~ I~
To get an idea ho~ a larger · ime
· ome re- K ::: ' is there',ore:•~
1

suits from a given increase in sp~ndmg: 'V-!e ~an , iV

follow the progress of the increased mJe.ction Hence, it follows that a maio'
around the circular flow of money as shown m the · cause a spend"inr spend·
structure will h . ing on in'
. . g c a,n th ,~.
table below·, economy. Th at cham 9f spendi roug1i ,L
. . h' , .J . ng, althou h ,1e
1!,,W mm1s mg magnitude at each sue . g of d'
1!,,Y 1!,,C . ., cess1ve i.
Round !!,,J (mpw ,".' O} ) cumulate to a multiple change in . step, Wil
$(bn) (mpc = 0.5) , . na1tonal ,.
. . in~rne.
I 10 10 5 I
- 5
. 2.5 '' 2.5
2 - 5 '."' ,.-
3 - i.s .. ..,...1.25 1. 1.25 Questio114
- - ---'--- --.c.....__
,.
4 -
- ' ...
' 1.25.I! ·_0.63
1
0.63 · Explain what' is m_eant by an equilibrium level of
tional income and discuss wliy this equilibrium .ghna.
. d. 1 . , m1 I
-
change 'm a eve, opmg co~ntry. [25]
;
'
All ,[N/O/P4!Q6J
$20 ' $10 n$10
rounds j· r • I

If ·say, $IO billion are spent on developing infra- ' Essay

structure. This will creat\: em~loy1m1e~t for. thou- National income (NY) is the total income earned by
sands of engineers, technicians and wpr.kers who residents of a country after dedu9ting capital consump- f
are directly or indire~tly involved in irifra.sfructure L < t ' •

tion. J;:quilibriu~ r~f~rs to a ~itu~tio~ :,vhere there is no

building. Initially the $10 billion spending ge1'erates
an equal amount of wage, rent, interest and profits
because spending and receiving income are two
sides of the same transaction.
The new employees will 'now have wages, profits
will have increased, and total income will have risen
by the $1 O billion. If we assume MPC = 1/2 and
MPL 1/2, we know households will spend $'.M bil-
lion .and the remaining $2.5. bi.Ilion. will be with-
, drawn as savings, jmports and taxes.,The ac\dition
to consumption further increases aggregate de-
mand. This time, the firms pr~ducing ,cpnsumer
goods find sale~ rising and stocks falling. They w(ll
• i~crease,pu~put, take on more labour, ~ay more m
wages and earn more prp~t. If we c~ntmue to cal-
culate increase in expenditure occurrm_g as a result
. xpansion in the economy we will be able to
o fth 1s e , . ffi . h .
calculate final change in NY. Thee ,ect IS s own m
the figure below:
I services
w le~el of national income. When the economy reac~es
w. rL-~--":?#~~-1,
L ~ --::::::¥-_:_:-r---:-----:;~1
y come.
fl!rther: tenqency_for natiqn_al , /nco11,1e to change The
.. Kexnes\an·the<:>ry of income, d_eterminatiop ou~li~es_two
appr9,ach!!S i11comN:~penditure and,leakages-mJectmns
ii) order to explain NY eqµ,ilibrium. ,
·Acc~r'ding to ~he· income expenditure approach the
level ofreal ..national income and, thus, employment is
determined by theJevel of planned aggregate expendi•
ture i~' an economy. Assuming an open economy with
~government the total planned expentlitures on go~ds
and services· comprises of consumer spending (C), m·
'vestment expenditure by firms on investment goods(!),
planned· government expenditure .on ,g'oods and s.er·
· (f"') . . to fiore'.gner.:
· demanding
vices "' , exports (X}relatmg M)
an economy's goods and ·services minus imports!
which represents the demand for, goods avd services
·from abroad. Thus, AE := C +I+ G + X - M.
There is•only' one•level of national income where agd
gregate expendiiure equals the total value of goods _an
.
produced and this is called· the' eqUI'( 1'brJUnl
this poi nt th ere 1s· no more tendency for na1·onal1 in·
come to ch . ay not,
ange. According to Keynes this m ·n-
however, be the full employment level of national I
The Ieakages · • . ative
m1ect1ons approach is an altern I
method of expr • f tiona
. . essmg the equilibrium level o na ,
mcome. Using th· . here.
is approach the equilibrium 1s w
 mies (Essays)
~el econo ~~-~ ~------:=-==~~---T~o~p~i~c3~.2~c:>~p~ag~e~
J ~e s+T+ M=I+ G + X Now, changes to the equilib. 7
I 'ti d as withdrawal from the circular come can also occur and th' rium 1evel of nat'10nal in-
esare cass1 'de 1e of the equation savings (S) + . Injections
· · • or leakages Acco ts can
d' be due to changes 1n .
ai(ag 1 ft s1 d . • . • r tng to the Ke •
V ()1 the ' (M) represent sum of withdrawals. mo e1, lnJect1ons are autonomous th . h Ynesian
l~oll'• (f) +irn?o~s estment (I) + government expen- dependent of the level of income So a1 •_s, t ey a~e ~n-
~es
O ri
the 'ght side inv . 1. .
rts (X) represent m ect1ons
(J) . h
mto t e
t
ves ment government expenditure and
· an increase _
10 10
o1 c(G)+expot'onal income equilibrium is said to
.... ·
ma exportsfuresults
parallel upward shift in the expenditure t·
d111l "" fl Ow Na I I d' . . nc ton
,,,.,,laf 1amount of leakages equals the total ea mg to an increase the size of the econom
ch•" •
hjeve when tota · • . m
. . Y, th at
ac . t'ons
of inJeC I . The two . approaches can be cally: 1
is, nationa income will rise. This can be shown gra , Phi-
8mount a Keynesian cross diagram.
shown on
planned
planned Y==E
expenditure expenditure
E,.

I E,
I
I
I
I
I
I
I
I
I
I I

0 y11 ye: Y21

real output
t---+:~
I I I
0 ye,: ye~,
,____., real output
+ I I I I I
I
I
I
I
I
I W=S+T+M +
I
I
I
I
Injections and I
I
I
I
I
I
I
I
I
I w
withdrawals I I Injections and I I
I I
J=I+G+X 1----~---::;:,f--- J2
I I withdrawals
0
Yi real output 0
ye2 real output
---+
The first of the two graphs shows that NY equilibrium
occurs at point e where Y + E. The graph just b:low From the graphs above we can see that an increase in
shows NY equilibrium where W = J. However a sttu~- injections has led to an increase in national income
tion where Y is not equal to E or W is not equal to J ts from Ye1 to Ye2• This increase in injections, particularly
called disequilibrium. For instance at y 1 ~lan?ed _ex- in a developing country, might have been due to in-
penditure exceed the level of output. In this situation -creasing investment by foreign multinationals, or else
there may be shortages of goods and services. Alter- the government may initiate development programs
natively
. stocks of goods already produced may be run. thus increasing in spending in the economy. Also ris-
' '
down. In both situation · firms are hkely
• to exp· and theirh ing exports, possibly due to depreciation of the
' • ·
output and thus national income will increase.· Onth e country's currency also causes X and hence injections
to increase.
other hand at income level y 2 firms Wt·11 find I that
b t ey
have increasing unsold stocks an I•t wt·11 not, ,e 1ong Another important point to note is that the resulting
d
before they reduce their output t us NY decreases. . . change in national income is much larger than the
h
. . . · ned expenditure change in injections. this is attributed to what is
If national income were at Ye, plan h nge level known as the multiplier effect. Multiplier represents the
Wou Id equal real o'utput. Firms
• wo uld notIdc remain
a un- number of times national income changes due to a
of output they produce and stocks ;.:~ube in equilib- given change in injections. Multiplier is denoted by K,
changed. National income would t . and the value of K can be found by:
rium, ..
planned mJec- K I/ . change in NY
In the second of. the two graphs at ly \ages and thus == mpw or K == - - - - - -
. are obviously greater than the ea . draw- . change in J
hons . Janned with Marginal propensity to withdraw (mpw) is the sum of
national income will increase. With p firms would be
marginal propensity to save (MPS), marginal propen-
als exceeding planned injections,;~~: there would be sity to tax (MPT) and marginal propensity to import
unable to sell all of their outpukt nd firms would ~ut (MPM). MPW is inversely related to the value of the
unplanned investment in · stoe decrease
a in n~fto nalhin-
back their o~tput, leadin~ to \y
in equilibrium w en
multiplier and generally, in a developing economy the
multiplier effect is larger because it has a smaller mpw.
Corne. National income I~ o~nned investment. This means that out of a given increase in income,
Planned withdrawals equa p
A Level Economics (Essays) Topi• 31 \

people spend relatively greater proportion on con-

M_P W is the proportion of a . . 11-a,
withdrawn from the . n 1ncreas . I
sumption. This leads to a higher mpc (marginal propen- c1rcula fl e 1n ""·
MPS, MPT .
and Mpu Mr
m. PS
ow, lt • ''Yth
isth a1 1 .
sity to consume) in developing economies. Since mpc propensity to save MPT _represent esuni s
and multiplier are directly related, so a higher mpc leads . ' ind· s Ill or
propensity to tax and MP
to a higher multiplier value and a large increase in na- · . Mr Ilcates Illaargin. al
propensity to imports. Th . e ates to rgtnai
tional income. withdrawals the lower is the higher the alllarginai
The rationale underlying the multiplier effect is that the e multi r1 lllou
The value of multiplier c , P er effp,,. nt or
economy has continuous flows _of expenditure and in- an a1sob ""'·
change in income
_, has occ urred be found
. aA11erth
come through which money spent by an individual is
mula:· Y usin g~efio e
recefved as income by another. Theref~re it follows r.
that an initial change in spending will cause a spend- change in real GDP
... I 6Y
ing chain reaction which will cumulate to a multiple m1tia change in injection == LV
change in NY. In a developing economy with a higher The multiplier effect occurs because a .
mpc, this increase in national income is expected to be vestment spending will create • rise in in.
even larger. Another point to note is that the develop- . h ·11 . incomes
' sorne of
wh 1c w1 m turn be spent and th ereby creat
ing economies usually operate below the full employ- e lllore
ment level of output, so increases in national income incomes. Let us assume that the MPW _ 1
are possible here, as the multiplier,effect of injections --. This
2
will occur.
Thus it follows that NY equilibrium occurs when Y = E will give us an MPCd -- .!
2 . Let us also assume that
or W=J. Also changes in equilibrium can occur due to
there is an increase . .in planned investme ntnthe
t.
changes in injections or withdrawals but the ratio of
economy of$ IO b1lhon. The rationale under! .
change in NY is greater than the change in injections th emu If1p r1er e ffiect 1s
· ,·1 Iustrated numerically inymg
the
or leakages due to the multiplier effect.
table below:

M t:.Y ,t:.C !J.W

Round
Question 5 ($bn) ($bn) ($bn) ($bn)
An increase in-investment will raise national in- J IO 5 5
come but_ an increase in the desire by consumers 2.5
2
to save will reduce national income. ,
3 1.25
. Explain why this is the case. 112]
4 1.25
[Jll/P4/Q6(a)J

Essay JO
20 IO
An increase in investment will act as an injection
into the circular flow of national income and, there- To get an idea how a larger increase in income will
fore, will generate a full multiplied rise 'in national result from a given increase in investment we can
' ' income through what· is known as the multiplier follow the progress of the increased .injection
effect. The reason is that all the money gets spent around the circular flow of money. If say, firms
and thus all of it goes to boosting aggregate de- ~l~nned to increase investment by $10 billion they
need • em PJ?Y thousands of engineers, tee hn·•
. · ,. to
1
·mand.
The tendency for a change in i~jections or with- c1ans and workers · and also need
· .
to buy machmer)'
drawals to result in a greater change in national an d raw material. .
income is known as multiplier effect: In fact multi- The hnew .em PIoyees
will . will now have wages, pro fi ts
plier magnifies business activities initiated by by the $ l bi . e , an d total income will have rt~
ave mcreas d · n
changes in injections or withdrawals. O lhon as shown in the table. Assuming
. In an open economy with government the value of MPC=J..
2 and M PW I
= -. we know households
multiplier can be estimated in advance by the
will spend $5 b'Ir
1 2 .
fonnula: be withdrawn ats" ar:1d the _remaining $5 billion will
addition to co avmgs, imports and taxes. The
nsumpti on fu rther increases aggre·
K = Marginal propensity to withdraw (MPW)
 .
5
(Essays)
norruc _:__-------------
~,"°' ~cO d . t·me the firms producing con-
fhlS I ' . . know from the multipt·
Topic 3 2
· Page 9
dem!III · nd sales rismg and st?cks falhng. . • •er that th .
~te r goods ti output, take on more labour, pay nat 1ona1 income will b e resulting fall in
sorlle will increased earn more profit. If we continue spending because this e greater than the fall in
11ieY ges an · d" • . t h means redu d . .
m o t e economy as peopl ce 1nJections
mo,v.., in Iwate increase in .expen 1ture occurring. as a · and less consum e .spend less · Th us extra
saving
calcll a ansion in the economy we will be P1•on
~ ~tofthis extp final change in NY as worked out
matters worse by lower,·ng . would on IY make
,. ,.1, calcu1a e unemployment. income and·increasing .
ableto ,
beloW: I From the above it follows that .
2-=-· . . an increase in in
vestment will brmg a proportionate! .-
0.5 • national
• •income while a r· Y .1arger. in-
crease in
: 1change in injections -is multiplied by ·11 ' 1se in savings
. WI reduce national income by a larger proportion.
'Jlten f multiplier to calculate final change m
the value o -20
. al •ocome. 10x2- . .
nation' . bl.
t:e. t is shown m the figure e ow.
The euec
w Question 6
W,l b
----"'7n--:-:--- Jl =I~+ G + X ----------
As part of the measurement of GDP governments
calculate the level of investment expenditure. ·
0 y
t:.Y What determines the level of inve~tment and how do
changes in investment expenditure affect GDP?
An increase in investment will raise the·· level of in-
jections from J1 to J2• Equilibrium will move from [12]
point a to point b. National income thus rises from [Ji 2/P4/Q5(a)j
Yeto Ye 1• The multipliei; is therefore:
K=~y Essay
M
Investment is an important component of national
Hence, it follows that an increase in investment will
income. It can be undertaken either by the private
cause a spending chain through the economy. That or the public sectors, and can involve the purchase
chain of spending, although of diminishing magni- of new plant and machinery, the building of new
tude at each-·successive step, will cumulate to a houses, factories or schools and the construction
multiple change in national income.
of roads and reservoirs. Net additions to stocks of
On the other hand a rise in saving could mean raw materials, semi-finished and finished goods are
more funds available to lend which might allow in- also classed as investment.
vestment to rise and economy to grow. However, if
Profit is an important factor in private sector invest-
everyone saves more then consequently they
ment, whereas public sector investment can be a
spend less. Increased saving and low spending political or social decision . .
affects businesses. Less spending means less de-
mand for goods and services and therefore lost When a private firm purchases a new machine the
orders for.firms. Firms will cut back production and expectation is that the yield from the invest~ent
lay off w~rkers. So 'the incom~ ofhousehold will will be greater than the cost of·buying machine.
fall. This phenomenon is cailed paradox of thrift The expected yield is difficult to calculate's'ince it
will occur over a number of years. ,Also;· a -given
and is illustrated by the graph below;
sum of money received next year will be worth Jess
W,J than the same sum received now. Therefore it is
usual to discount these yields to their pr~sent
value and ~o express the return over the initial cost
as a rate. This rate will be referred to as the mar-
ginal efficiency capital (MEC).Thus if the MEC is
greater than the real rate of interest the investment
should proc~ed. The relationship between MEC
and rate of mterest is illustrated in the ft" ure
below. g
....
A-.
increase in savings' at all levels Of m
· come
. will
.
I ,· function.
ead to an upward shift in the savings OB We
Equilibrium income•~ill fall from OA to ·
_A_L_e_v_e_l_E_c_on_o_m_,_·cs_:(Es_s_a..:__y_s:__)_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _T•Opie 3
•2 CJ
being partly induced Th' Pt91 ,0
. I . is mea
MEC&Rate 1s re ated to national inc ns that i
. ome Wh nvest
of interest consumer demand increas ·. en, for . lllen1
. es 1t ca h 1ns1,.
f1 -------- I on investment. The rate of h n ave '<lflCc,
I 'JI h c ang
come w1 t us bring about h e of nati 'ct
an effi
I
I
net investment through wha;. anges in the ~~al in.
fl --------r---
I
I tor principle. is called the a ,Vel of
I
I
I
I
Ccelera
I
I
I
I
MEC GDP is the total market value f ·
. o ~lfi I
services produced within a na &oods
0 k, k2 stock of . . d country i and
capital time peno . The level of GDP 1s . deten one
.1 ,•c ar
p Ianne d aggregate expenditure I.e.
• nn ned bY
By investing, a firm can build up a stock of capital AE =C +I+ G + (x - m)
goods and, as with labour, capital is subject to the
law of diminishing returns so the MEC will fall. So The term. AE. denotes the
, .total sp en d'ing on
long as the MEC is greater than the rate of inter- an d services produced in an econ Sood,
of four elements: omy. 11 consisu
est, the investment is worthwhile. In figure above,
investment should cease once k1 is reached at an Consumer spending (C)
interest rate r1. A fall in the rate ofinterest to r2 will . Investment expenditure (I)
lead to a rise in the capital stock from kl to k2 • The government spending (G)
increase in capital stock, k2 - k1, will ~equire new
• ' I Net expenditure on exports and import
investment to take place. The size of the capital (X-M), , s
stock, therefore, varies with the rate of interest.
In our explanation above, the rate of interest was Investment is one
, . of the four compone n1s of
· assumed to be the rate at which firms have fo bor- planned ~xpend1ture therefore, a change in the
row money. However, a large part of investment by level of investment expenditure would in tum
firms is financed from retained profit. This does not cha~ge the planned expenditure leading to a pro-
alter the relationship between the rate of interest portionately greater change in the country's GDP
and investment. Thus, the higher the rate of inter- thrqugh what is (mown the multiplier effect.
est on savings, the higher the opportunity cost of We define multiplier as the ratio of the change in
investment and hence the lower will be the amount GDP to •the change in planned expenditure. The
of planned investment in the economy. extent of change in GDP can be measured by the
Although rate of interest is the main factor influ- following: .
encing investment but several other factors can K= change in GDP I
also lead to a change in investment. For instance Change in injection or K = MPS+ MPT +MPM
if business executives become more optimisti~
To elaborate we assume that the economy is open
about future business, the planned investment
curve will shift to the right; a pessimistic outlook with government sector and there are unemployed
will shift it t<? the left. Business expectations may resources. The MPS, MPT and MPM are OJ, 0.1
be based on changes in the domestic political and an~ 0.1 respecti.vely and that the firms increase
th e•r level of planned investment by $100 million.
economic climate, international r~latlons, popula-
tion growth and stock market conditions. By applying the formula we can calculate the value
of K in this economy and then the resulting
Furthermore, a rapid rate of technological progress change in GDP.
stimulates investment. The development of a more
efficient machine, for example, will lower production 2.5=-----
costs, increasing the expected rate of net profit
h 0.3 + 0. I+ 0.1
from investing in new machine. Finally, business
ence effect GD · 1·n
ok to expected profits after taxes in mak-
vestrn~ t · on p is 2.5 times of change in •
Owners lo n i.e. $100 x 2.5 = 250.
ing their investment decisions. An increase in busi-
The cause 0 f . . .
in injectio . multiplier effect is that, any increase
ness taxes will lower profitability and lowers the
. d . .
n into the ec . d treaJll
level of planned investment; a tax re uct1on will
of new in onomy will pro uce as
comes thro h d . . d' for
stimulate investment. example- if fi ug a d1t1onal spen mg,
rn ., inns to inv t h' ·11 tead 10
I the preceding analysis we assumed that invest-
. ore people b . es more, t 1s WJ
n t was planned or autonomous. This is an in_cornes bein ei~g employed and hence more
men t' n which we now relax, with investmentwill then spengdpaid to house-holds. Households
assump io do . Part of th· • . on
mestically produce 1s increased mcom_e
~ \ d good, (the rem,;nd"w,11•

./
 . s (ets•Y_s)_ _---:--~~-------~T~~-
nofT1/C Opie 3.2 C Page 11
~i ccO ,M,,' increased consumption will en- down the rate of interest t .
wn)· 11,1s oduce more goods to meet the larly, if the rate of intere ~ward equilibrium. Simi-
1~t11dr8 firJllS to~~ thus employ more people and would have insufficien: ;ere below Re, people
,o~ras~. firJllS wilroduction. This leads to even would sell securities thus lo on~y bal~nces. They
111BJ1
oe factors
of .P paid out to house ho Id s. Con- · · the rate of interest
ra1smg ' wenng
unr'I ·t their prices
· and
oth'r ·ncof1'1es being·ncrease yet again, and so the librium level. 1 1
reached the equi-
ore , .II thus I • • • • fi .
111 tioO w1_ Since mult1pher 1s not m mite, Changes i ·
s~~;,55 conu~ues. e 1·n 1•niections would not cause .· n money_ supply will affect national in-
nfO""- an increas u h . come via changes m the rate of interest Let'
r ..,/ore. go on ris-ing forever. Eac time sume th t h · · s as-
t11(;1•1' • corne to . a monrtary aut orities seek to adopt easy
1·100al 10 • xtra 1·ncome they will save some monetary d
pa ce1ve e f. . m~asures a.n a~e~~t to increase money
f'ple ;sorne of it in taxes and sp~nd som~/b it supply, say, by lowering hqu1d1ty ratio of commer-
of i~ paorts Hence income generatlohn wou . e- cial ban~s or buying securities ,through open mar-
on j(llp · •vely smaller after eac transaction. ket operation. ·
rogress1
come
P e in the level of investment is ex-
a chang . part I part 2
'fhUS ult in a proportionately larger change rate of rate of
ted to res interest
inGDP of an economy. interest ·

~est/on7 _ _ _ _ _ _ _ _ _ __

E lain, using the concept of the multiplier, the 0 Me Me, money 0 I,, 11
'
ossible link between a fall .m .interest rates an d an
des ired investment
increase in national income. [12] expenditure
[N13/P4/Q5(a)] Fig. 2
These measures shift the supply-curve of money
&say from MS to MS I as sfiown in the first part of the
graph. Consequently, there is excess supply of
In the money market the condition for monetary money at the existing rate of interest Re. People
equilibrium is that the rate of interest will be such still wish to hold only Me of money balances, but
that everyone is just willing to hold the existing Me 1 is now availab.le. In order to eliminate their
supply of money, i.e. interest rate does the job of excess holdings of money, People attempt to buy
equating the quantity of money demanded to the bonds and securities. This attempt of buying
available supply and hence produces monetary bonds and other financial assets increases their
equilibrium. In the figure below, we see how the price and subsequently lowers the rate of.interest.
interest rate produces monetary equilibrium. When i~terest has fallen to Re 1 the quantity of
money demanded will have risen to equal the av~il-
rate of able supply of Me,. Monetary equilibrium is, thus
interest re-established, though at a lower rate of interest..
The curve in the part ·2 of the graph is called a
marginal effici~ncy of investment curve (or just a
demand for investment curve). MEC curve shows
Re
the relation between planned investment and the
LP rat~ of i~terest, assuming all oth~r things are equal.
It ~s der!ved fro!TI prospective yield of one more
Mc money unit
. of investment . . and_ the. cost. ·of obt • . 1.
, ammg 't
~irmMs EmCake _thh_e1hr investment _decisions by com par- .
Fig.1 mg wit t ,e rate of interest . For •·n stance, 1'f
Equilibrium is achieved with a rate of intere~t Re the
· .expected real .net rate of return on an m . d.1v1'd ua
1
lllld the quantity of money Me. If the rate of mte~- pro;ect
. (MEC)
. , is greater
. than th e rea 1· rate of
CSt Were above Re people would have money ba • mterestk, mvestm~nt is_profitable and hence is
ances surplus to ' their needs. They wouldTh' use underta en. Thus investment dema d h
· n curve s ows
these to buy securities and other assets. d . is that the Iower the rate of interest
1
th 1 .
.. , e argerw11l be
· · and rive
would drive up the price of securities the num ber of investment opport . . h ,
u111t1es t at will
 A Level Economics (Essays)
Topic 3.2
Paae 1i
show a profit and, hence, the larger the volume of other factors of production. This I
investment expenditure that firms wish to under- . b . . eads to
talce. more incomes eing paid out to hous h even
sumpt10n. wt·11 thus increase
. yet againe olds · Con.
Note that, because both parts of the Figure above .
process continues until· NY rises by full•~d~th. e
have the interest rate on the vertical axis, the inter- effect. rnu1t1plier
est rate can be compared between the two. Both
parts show an initial equilibrium with the quantity
of money of Me and an interest rate of Re. When
the equilibrium is disturbed, say due to an increase
in the money supply to Ms 1, the rate of interest
falls to Re 1. Part (ii) of the Figure tells us that the
fall in the interest rate from Re to Re 1 increases
desired investment expenditure from I0 to l1.
So far, we have seen that an increase in the money
supply leads to a fall in the interest rate which, in
tum, results in an increase in desired investment
expenditure. We extend our analysis to finally fig-
ure out how these changes subsequently affect NY.
Withdrawals
& Leakages
W=s+t+m
r---------~;;,c:..-Jl = l2 + G + X

Fig. 3
Equilibrium NY can be found by W = J. The with-
drawals function is the vertical sum of the net sav-
ing, net taxes and import functions. Similarly, the
injection function is the vertical addition of the in-
vestment, government expenditure and export func-
tions. Initially, the equilibrium can be located at
point a, indicating YI as the equilibrium level of NY.
A rise in investment expenditure shifts the J func-
tion upwards and will cause NY to increase
(Y 1 - Y2) by more than the increase in investment
(be). The number of times that the increase in in-
come (NY) is greater than the increase in invest-
ment is known as the multiplier (k).
So an increase in injection into the economy will
produce a streruv of new incomes through addi-
tional spending that causes a multiplier effect. For
example, if firms to inv~st more, this will lead to
more people being employed and hence more in-
comes being paid to house-holds. Households will
then spend part of this increased income on do-
mestically produced goods (the remainder will be
withdrawn). This increased consu_~ ption will en-
courage firms to produce more goods to meet the
deman. d Finns wilJ .thus
-. employ more people and