Cambridge International as and a level Economics Ebook

Equilibrium and equity: 
The circular flow of income shows 
how and why macroeconomic equilibrium can change.
KEY CONCEPT LINK
The multiplier
Th
is is also known as the national income multiplier 
or the Keynesian multiplier. It shows the relationship 
between an initial change in spending and the fi nal rise 
in GDP. Th
e multiplier eff ect occurs because a rise in 
expenditure will create incomes, some of which will, 
in turn, be spent and thereby will create incomes. For 
example, if people spend 80% of any extra income, an 
increase of government spending of $20 billion will 
cause a fi nal rise in GDP of $100 billion. Th
is is because 
the initial $20 billion spent will create higher incomes. 
People will spend $16 billion of these extra incomes, 
thereby generating a further rise of incomes. Of the 
$16 billion, $12.8 billion will be spent. Th
is process 
will continue until incomes increase to $100 billion 
and the change in injections is matched by the change 
in withdrawals.
Households
Firms
Consumer
spending on
goods and services
Factor payments
(wages, interest 
profit and rent)
Factor services
(labour, capital
entrepreneurship,
and land)
Goods and
services
Figure 9.14 
The circular flow of income in a closed economy
Households
Firms
Consumer
spending on
goods and services
Factor payments
(wages, interest 
profit and rent)
Factor services
(labour, capital
entrepreneurship,
and land)
Goods and
services
Direct
taxes
Saving
Exports
Government
spending
Government
spending
Imports
Indirect
taxes
Figure 9.15 
The circular flow of income in an open economy