Income and Expenditure

This chapter will consider Income and Expenditure. To provide an overview, the chapter will first consider the circular flow of money through the economy, before discussing demand, as well as income through the IS-LM model. Through all of this it is important that we remember the simple production function as it provides us with a basic understanding of aggregate demand, and the factors which influence it. The simple production function states that output (Q) is a function (f) of:  (is determined by) the factor inputs, land (L), labour (La), and capital (K), i.e.

Q = f (L, La, K)

Circular flow of Income Model

The visual below provides a basic view of the circular flow of money within an economy:

Circulare flow simple

Essentially, in this case there are two actors, namely the ‘households’ and the ‘firms’. The firms supply income to the households in exchange for labour hours worked, while the households then complete the circle by spending their wages in the economy and sending spending income back into the firms. This is the ‘basic’ form of the model as it considers an unbroken loop, however at the same time it does not include potential linkages from the circle which will now be discussed.

To start, consider the consumption function which suggests that aggregate demand in an economy is a function of consumer spending, investment, government spending and trade (exports minus imports). To start, an expansion of the model would consider the government also in the circle. There also is the  consideration of factor income, which will include the income that is earnt from renting land/ gaining a return on capital etc.

Another factor to consider will be trade and the impact that the trade balance can have. For instance, the UK has a trade deficit, meaning that it imports more than it exports. Given this, there is a flow of national income out of the economy. This is what would be described as a leakage from the economy. Other countries have a different impact. While these cash injections can be a positive when it comes to increasing national income, there can be an issue when injections are too high.

Finally, savings and investments must also be considered. For instance, when a household receives their wages they have two choices; namely (1) spend, or (2) save. If the household chooses to save their money they it exits the circle. It would only re-enter if the bank lent the money out to another household, again seen as a leakage/ and injection into the system. However, an interesting consideration here is that sometimes the flow of money can create inequality in an economy, which in turn may restrict spending.

Determinants of National Income

Several factors can be mentioned when the national income, and so the size of the economy is considered. Initially, the aggregate demand function can be considered, which considers the following factors:

Aggregate Demand = Consumer Spending + Investment + Government Spending + (Exports - Imports)

The size of the economy is dependent on spending from consumers and governments, as well as spending by businesses in the form of investment. To add, there is also the consideration of international trade, which as mentioned above can either be seen in inject/ or leak income from the national economy. However, behind these factors are more in-depth suggestions. For instance, consumer spending will be dependent on wages in the economy, which in turn may be dependent on productivity and labour supply/ demand. So, the size of the economy, and so national income will be dependent on the pool of labour seen in the economy, and how this labour is used. This then brings into consideration productivity, given that the level of productivity can determine the wage rate which the business is willing to pay.

Secondly, consideration can be paid to capital, which is directly linked with investment by businesses. For instance, a business may choose to invest £10Million into new machinery which will help automate production. The idea behind this investment would be that by automating some production, worker productivity can be raised, in turn allowing total production to increase. With this, national income will rise. Investment may not just be seen in capital goods, but also seen in terms of education/ training and enterprise, factors which may also be influenced by government spending. State of technical knowledge is also one of the very important factors which influences the size of the national income. The methods of production now-a-days have become so much roundabout that unless advance technical knowledge is available in the country.

An interesting model to consider here is Solow’s Model of Growth, one which considers two factors to be responsible for long-term, sustainable economic growth. These are namely capital and labour. The idea here is to achieve long-term, and sustainable economic growth, a country must either (1) increase the size of the labour force, or (2) increase the amount of capital employed which links in with labour under the assumption that increased capital investment can increased productivity per worker. The link here with national income is that increased productivity per worker should increase the wage rate, which in turn will increase consumer income, allowing for greater spending.

Keynesian Cross Model

When discussing expenditure, the Keynesian Cross Model could be considered, with an example shown below:

The model demonstrates the relationship which exists between aggregate demand and real GDP. In this diagram, a desired total spending curve is drawn moving upwards since consumers would be expected to increase their demand for goods/ services as disposable income rise, which in turn would increase national output if we consider the aggregate demand equation mentioned above. Aggregate demand may also rise given investment, with the idea being that if demand increase, businesses will be more likely to increase investment as they need to increase supply onto the market. Equilibrium in this diagram occurs where total demand, AD, equals the total amount of national output, Y, here, total demand equals total supply


As mentioned, we can have several leakages from the aggregate demand model above which could lead to a situation where wages/ and income is increasing but their impact on national output is limited. This is like what has been mentioned above in the circular income flow. For instance, imports are a leakage from the model as consumers are spending money, but the money is then moving out of the national economy to international businesses. In economics, the general rule is that markets will also move to achieve equilibrium in the long-run. In a situation where imports are higher than exports, we say there is a trade deficit. To combat this, a return to an equilibrium, economists would suggest that the national currency will depreciate, in turn making imports more expensive, and exports cheaper for foreign buyers.

Intertemporal Choice

Intertemporal choice is a theory which considers how people make choices relating to what/ how during various points in time. It is essentially looking at the pay-off, and the value that people assign to goods/ services over different points in time. This becomes interesting in economics given that the model will consider how a decision in the present can impact on the possibilities in the future. Most choices require decision-makers to trade off costs and benefits at different points in time. Taking this from a consumer perspective, the theory could be used to understand why a consumer may look to purchase a car today, using finance which will limit their spending power in the future. This could be seen as ‘Discounted Utility’ - which is calculated as the present discounted value of any future utility. Another example of this could be seen in policy decisions, whereby a government may choose to invest into education/ infrastructure etc., now given the present value of the future utility.

Random-Walk Hypothesis & Permanent Income Hypothesis

The Random-Walk Hypothesis suggests that changes in consumption should be unpredictable, based on the work by economist Robert Hall. The permanent income hypothesis is an economic theory which seeks to consider consumption in regards to a consumer’s lifetime, hypothesising that a consumer will spread out their consumption over their lifetime. First developed by Milton Freidman, the theory seems to go against Keynesian economists, the model considers that a person’s consumption at any point in time is determined not just by their current income, but also by their expected income in future periods.

Demand for goods

When it comes to discussing the demand for goods it must be remembered that not all goods are the same. For instance, we can consider that some goods are essential for consumers while others are non-essential, meaning that they will act differently to changes in income and expenditure. As mentioned in economics, the demand for a good can be impacted by supply, the price and the income of the consumer.

However, as consumers, the demand may react different between chocolate and petrol. For example, if a consumer’s income became constrained, then they may need to cut their expenditure. To them, petrol may be an essential good needed to power their vehicle for work/ travel. At the same time, chocolate may be un-essential, meaning that the consumer will cut demand more than the rise in price. With this, we could consider this good to be elastic. To determine the elasticity of a good the following equation can be considered:

For instance, if the price increased by 10%, and demand fell in response by 12%, then it would be 12/10 = 1.2.

As mentioned, a good can either be elastic or inelastic. If the result is greater than 1, then the good is elastic. If it is below 1 then the good is considered inelastic. If the result is 1 then we call this unitary elastic. This becomes interesting when linked in with how a business may act in the market; be it with production or strategy. For instance, if a specific good is classed as elastic, the business may be reluctant to increase the price, given that expectation the demand will fall by a higher percentage. Profit maximization in this case may be achieved through quantity as opposed to price.

IS/LM Model

To begin, the IS-LM model stands for the ‘Investment-Savings, Liquidity-Money’ model. The model fits within the Keynesian idea of economics, showing how the market for economic goods interacts with the loanable funds market. When it comes to breaking the model down, there are three critical components to the model; liquidity, consumption and investment. Per this theory, the liquidity available in the economy will be determined by the size, and velocity of money supply. Levels of consumption/ investment are determined by the marginal decisions of actors.

Interest rates also come into consideration given the impact that such can have on output. So, with this, the IS-LM graph examines the relationship between two variables, namely real output, or GDP, and interest rates. The entire economy is boiled down to just two markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point. This is sometimes referred to as ‘Keynesian Cross’.

Image result for IS/ LM model

So, we can see that the IS curve is sloping downward. This assumes that the level of consumption/ and investment is negatively correlated with interested rates while being positively correlated with GDP. This is justifiable. For instance, if interest rates increase then the cost of borrowing becomes more expensive, potentially deterring customers and businesses from lending. From the business perspective, increased interest rates will increase the cost of lending for capital expenditure, which in turn may increase the desired rate of return on projects, making some financially unviable. So, another way to consider the IS curve would be as a visual to all the combinations of income (Y) and borrowing ® which equal total supply, shown in the equation below:

Yd(Y, r) = Y

Where the Y on the left-hand side stands for income, r equals the cost of borrowing which could also be seen as the interest rate, and Y on the right-hand side stands for total supply.

To conclude, this chapter has considered income, and expenditure. Essentially, the economy can be seen as a circular flow of cash, mainly between businesses and households. Businesses pay households for working, while the householders then give their money back to the business through spending on goods/ services. However, as mentioned there are several leakages to consider. Taxes are one, however this would be injected back into the economy through government spending as denoted in the consumption functions; namely AD = C + I + G + (X-M). Secondly, we can consider savings from both consumers and businesses. The scale of this would be dependent on the marginal propensity to save; however, in any case it is a withdrawal. Although, what could be mentioned here is that savings do re-enter the economy as banks lend out the money to consumers/ businesses; although there is still some leakage for those hoarding cash at home etc., or through the fact that financial institutions do have to keep a certain level of cash back as capital. Finally, the third leakage mentioned was imports, a major issue for the UK given that the economy remains in a current account deficit, whereby more money is flowing out of the economy than coming in. In this case, economic theory would suggest a change in the value of the national currency would change to bring to the market back into equilibrium. In the case of the UK this should depreciate the national currency, which in turn would make imports more expensive, and exports cheaper for international customers.

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