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9708 · 4.2

Introduction to the circular flow of income — practice questions

Practice and worked examples for 9708 Introduction to the circular flow of income. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

In an economy, MPC = 0.8. The government increases spending on infrastructure by $50 million.

(a) Calculate the simple multiplier. (b) Calculate the total increase in national income. (c) If MPS = 0.2 and MPT = 0.1 (marginal propensity to tax), explain why the actual multiplier would be smaller.

Show solution outline

(a) Multiplier k = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5

(b) Total ΔY ΔY = k × ΔG = 5 × 50m=∗∗50m = **250 million**

(c) Smaller actual multiplier With tax leakages, each round of spending is taxed away. The full formula includes MPS + MPT + MPM (marginal propensity to import). Higher leakages → smaller k → less than $250m final increase.

Worked example 2

An economy has the following planned values for injections and withdrawals (in $ billions):

  • Investment (I) = 200
  • Government Spending (G) = 250
  • Exports (X) = 150
  • Savings (S) = 180
  • Taxation (T) = 220
  • Imports (M) = 170

(a) Calculate total planned injections and total planned withdrawals. Is the economy in equilibrium? (b) What is likely to happen to the level of national income? Explain your answer. (c) What change in taxation would be required to bring the economy to equilibrium, assuming other components remain constant?

Show solution outline

(a) Calculate Injections (J) and Withdrawals (W) Total Injections (J) = I + G + X J = 200 + 250 + 150 = $600 billion

Total Withdrawals (W) = S + T + M W = 180 + 220 + 170 = $570 billion

Since J ($600bn) is not equal to W ($570bn), the economy is not in equilibrium.

(b) Impact on National Income Since total injections ($600bn) are greater than total withdrawals ($570bn), there is a net injection of $30bn into the circular flow. This means aggregate demand is higher than the current level of output. Firms will see an unplanned fall in their inventories. To meet this excess demand and rebuild stock levels, firms will increase production. This leads to a rise in national output, employment, and therefore national income will rise.

(c) Change in Taxation (T) for Equilibrium For equilibrium, J must equal W. Currently, J = $600bn and W = $570bn. To achieve equilibrium, total withdrawals (W) must increase by the difference between J and W. Difference = J - W = 600bn−600bn - 570bn = $30 billion.

We need to increase W by $30bn by changing T. The new level of withdrawals should be $600bn. New W = S + New T + M 600bn=600bn = 180bn + New T + 170bn170bn 600bn=600bn = 350bn + New T New T = 600bn−600bn - 350bn = $250 billion.

Change in T = New T - Old T = 250bn−250bn - 220bn = +$30 billion. Therefore, taxation must increase by $30 billion to bring the economy into equilibrium.

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