9.1 The Circular Flow of Income

2026 Syllabus Objectives

By the end of these notes, you should be able to:

  1. Understand the multiplier process — define the multiplier, use its formulae in closed and open economies, calculate propensities to save, consume, import, and tax rates, and determine national income using the multiplier.
  2. Identify the components of Aggregate Demand (AD) — explain consumption, savings, investment, government spending, and net exports, including the difference between autonomous and induced components, and understand the accelerator.
  3. Distinguish between full employment national income and equilibrium national income — explain and illustrate inflationary and deflationary gaps.

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Section 1: The Multiplier Process

What Is the Multiplier?

When someone spends money in an economy, that money does not just disappear — it gets passed on. Imagine a government spends 100 dollars building a road. The construction workers receive that 100 dollars as income. They then spend some of it at local shops. The shopkeepers earn income and spend some of it too. This chain reaction means that the final increase in national income is larger than the original injection of spending.

The multiplier is the number that tells us how many times bigger the final change in national income is compared to the original change in spending (the injection).

Definition: The multiplier is the ratio of the change in national income to the initial change in aggregate demand (spending) that caused it.

In formula form:

Multiplier (k) = Change in National Income (ΔY) ÷ Change in Aggregate Demand (ΔAD)

Or rearranged: ΔY = k × ΔAD

Why Does the Multiplier Exist?

Every time income is received, people spend some of it and save (or pay tax on, or spend on imports with) the rest. The part they spend becomes someone else's income, which gets partly spent again, and so on. The multiplier keeps going until there is no more spending left in the cycle.

Withdrawals (Leakages) — What Stops the Chain?

Three things can take money out of the circular flow and reduce the size of the multiplier:

  • Saving (S) — money set aside and not spent
  • Taxation (T) — money taken by the government
  • Imports (M) — money spent on goods from abroad, leaving the domestic economy

These are called withdrawals or leakages.

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