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9708 · 9.1

The circular flow of income — practice questions

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

Worked example 1

In an open economy, households save 20% of income, the government collects 25% in taxes, and 15% of income is spent on imports. Planned investment is $40bn, government spending $60bn, and exports 50bn.50bn.

(a) Calculate the marginal propensity to withdraw (MPW). (b) If savings are currently $30bn below the level consistent with equilibrium, by how much must national income change to restore equilibrium? (Use multiplier = 1/MPW.) [8 marks]

Show solution outline

(a) MPW = MPS + MPT + MPM = 0.20 + 0.25 + 0.15 = 0.60

(b) If S is $30bn below equilibrium S, then injections exceed withdrawals by $30bn (or equivalently, withdrawals need to rise by 30bn).30bn).

Multiplier = 1/MPW = 1/0.60 = 1.67

ΔY = excess injection × multiplier = 30bn×1.67=∗∗30bn \times 1.67 = **50bn increase** in national income.

At higher Y, savings, tax, and imports all rise until I + G + X = S + T + M again.

Check logic: Rising Y increases withdrawals via the 60% MPW until the $30bn gap in S is closed.

Worked example 2

An economy is described by the following data (in $ billions):

  • Investment (I) = 200
  • Government Spending (G) = 300
  • Exports (X) = 150
  • Savings (S) = -50 + 0.1Y
  • Taxation (T) = 0.2Y
  • Imports (M) = 0.15Y Where Y is the national income.

Calculate the equilibrium level of national income (Y). [6 marks]

Show solution outline

Step 1: State the equilibrium condition. The economy is in equilibrium when total injections equal total withdrawals. J = W I + G + X = S + T + M

Step 2: Substitute the given values and functions into the equation. 200 + 300 + 150 = (-50 + 0.1Y) + (0.2Y) + (0.15Y)

Step 3: Simplify both sides of the equation. Total Injections (J) = 650 Total Withdrawals (W) = -50 + (0.1 + 0.2 + 0.15)Y = -50 + 0.45Y So, the equation becomes: 650 = -50 + 0.45Y

Step 4: Solve for Y. Add 50 to both sides: 650 + 50 = 0.45Y 700 = 0.45Y

Divide by 0.45: Y = 700 / 0.45 Y ≈ 1555.56

Step 5: State the final answer. The equilibrium level of national income is approximately $1555.56 billion.

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