Imagine the economy as a simple model where there are just households and firms. The households hold all the factors of production – land, labour, capital and enterprise – and the firms are the producing units. Money moves from households to firms when they buy goods and services; and money moves back to households as payment for the use of the factors of production in the form of rent, wages, interest and profit. In this very simple model, known as the circular flow of income, money circulates from households to firms and back again, and the more that households spend and the more the firms produce, the higher the levels of incomes. It odes not matter which way you look at it, the income and output in the economy should always be the same, and they are measure by gross domestic product (GDP).
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There are three leakages (or withdrawals) from the circular flow of income: savings, tax and imports. If you hide your money under your bed, the economy will slow down a little as there is less money in the circular flow. Similarly, if the government takes money in the form of tax, and does not spend it, or if people buy more things from abroad than they export, the economy will slow down as money leaves the circular flow. These three leakages effectively determine the size of the multiplier.
By contrast, there are three injections into the circular flow. These are investments – which is an increase in capital stock – government spending and exports. These all increase the circular flow and a change in any of these will be magnified by the multiplier.
The multiplier is the number of times a change in incomes exceeds the change in net injections that caused it. For example, if there is a £10 million increase in export values, the inward flow of money to the UK will be re-spent within the UK. Then the money is spent it will become other people’s incomes. THese incomes will be re-spent and so on.
The importance of the multiplier is that if there is any change in spending in an economy, the final impact on incomes will be much greater than the initial impact. The greater the leakages, the smaller the multipler. The formula is based on ow much of any extra pound earned is re-spent within an economy: that is, the marginal propensity to consume. The size of the multiplier in the UK is approximately 1.4, but in developing countries it is often higher, which partly explains their higher growth rates. For example in a country with a multiplier of 3, a net injection of $10 million will cause a $30 million increase in incomes in total.
If all the injections equal all the leakages, then the economy will be in equilibrium; if injections are greater than leakages, the economy will grow; and if leakages are greater than injections the economy will contract.
Wealth is the sum of all the assets in the economy. In the UK, most wealth is held in the form of housing (almost 60%); the other major forms of wealth are stocks and capital assets. Wealth is a stock concept, whereas income is a flow concept – this means that wealth does not have a direct effect on the circular flow of income, but changes in wealth are likely to have an income on incomes and spending. For example, if you live in a property that increases in value, you might geel more confident about spending in the economy and your increased spending will then be part of the circular flow of income. Moreover, if houses become more expensive, someone could go to their local mortgage provider and request mortgage equity release; that is take out a loan based in the increased wealth. When that loan in spent, the circular flow increases. By contrast, when capital markets take a downturn in the USA< people living on pensions in the UK might find their incomes fall because dividends on pension funds are often based on the capital gains of shares.