National Income

National Income – Factors affecting the size of National Income

business_square2

Key Learning Outcomes


  • Understand the factors that determine the size of a country’s National Income
  • Understand the concept of the multiplier
  • Distinguish between a closed economy and an open economy
  • Factors that affect the savings rate in the Irish Economy

Introduction: Factors affecting the size of National Income


The Actual level of National Income (Y) in a country is made of the following five components: Consumption (C), Investment (I), Government expenditure (G), Exports (X) and Imports (M). The first four of these create income within the country, while imports create income in other countries. Thus the actual level of national income in an economy can be expressed as follows:

National Income Equation: Y= C+I+G+X- M

Consumption:
When people receive income, they spend most of and save part of it. So we can say that Income (Y) equals consumption (C) plus savings (S): Y= C+S

Consumption depends on Income, Availability of Credit, Rate of Interest and Rate of Taxation.

The marginal propensity to consume (MPC) is the fraction of extra income that is consumed or spent.

mpc-cc over ci
Investment:
depends on the rate of interest, the expectations of business people, government expenditure and state of technology.
Government expenditure:
is independent of the level of Income. The size of government spending will depend on the decisions of government as laid down in the annual budget.
Exports:
depend on the level of income generated abroad.
Imports:
depend on Income, value of the Euro and the availability of goods in Ireland.
Marginal Propensity to Import (MPM) is the proportion of each additional unit of income that is spent on imports:

mpm-cim over ci
A closed economy does not engage in international trade, while an open economy engages in international trade. An open economy sells (exports) abroad and purchases (imports) from abroad.

The circular flow of income represents the flow of resources between the different sectors of the economy. Anything which causes the circular flow of income to increase is called an injection. Anything which causes the circular flow of income to fall is called a leakage.

Injections are Investment (I), Exports (X) and Government Spending (G).

Leakages are Savings (S), Imports (M) and Taxation (T).

The Multiplier shows the precise relationship between an initial injection into the circular flow of income and the eventual increase in national income resulting from the injection.

The marginal propensity to save MPS = 1 – MPC (marginal propensity to consume)

The marginal propensity to pay tax (MPT) is the fraction of extra income that is paid in tax:

mpt-ct over ci

The Multiplier formula in an open economy is:

one_over_mps

Sample Exam Q&A


Question

A (i) Explain what is meant by the term ‘Multiplier’ (25 marks)

Sample Answer A (i)

The multiplier shows the relationship between an (initial) injection into the circular flow of income and the eventual total increase in national income resulting from the injection.
(A) It has been estimated that in the Irish Economy MPT = 0.22, MPM = 0.30, MPS = 0.28.
(ii) Calculate the value of the Multiplier in the Irish economy. (8 marks)

Sample Answer A (ii)

Method 1

one_over_mps

one_over_point28

one_over_point8

= 1.25

Method 2

mpc_equals_one

one_over_one minus

one_over_one_minus_072

one_over_point8

= 1.25

Either method will do.

(A) (iii) Outline briefly how taxes affect the value of the Multiplier. (9 marks)

Sample Answer A (iii)

Taxes decrease spending within the economy / taxes are a leakage from the circular flow of national income.
When spending decreases, less economic activity is generated within the economy.
The value / magnitude of the multiplier decreases.
(B) “Irish economic recovery continues making Ireland the fastest growing economy in the E.U.”
Discuss the economic effects of an increase in the rate of economic growth on the Irish economy.
(20 marks)

Sample Answer B

There are positive and negative effects.
Positive economic effects: (Any 4 Points @ 5 each)
1 Increased Employment
Economic growth will lead to increased demand for goods and services with more labour being demanded to produce this.
2 Improved government finances
With a rise in spending – indirect tax revenue rises, more people at work will result in an increase in direct tax revenue and expenditure on social welfare should fall.
3 Effects on Balance of Payments
If the increase in the rate of economic growth is export led then the balance of payments position improves.
4 Improved standard of living
Economic growth will result in increased wealth in the economy allowing us to buy more goods and services / a reduction in poverty / better state services.
5 Effects on migration
If jobs opportunities exist then people who had planned to emigrate may stay here and more immigrants may be attracted to the economy.
6 Investment opportunities
Economic growth indicates a growing economy and this may attract additional investment.
Negative economic effects: (Any 4 Points @ 5 each)
1 Inflationary pressures
With a rise in the level of economic activity the level of demand- pull inflation will rise.
2 Use of scare resources
Economic growth results in an increased demand for scarce resources e.g. oil. Increased demand may involve damage to the environment.
3 Increased demand for imports
Economic growth increases incomes and spending power, and demand for imports may rise worsening the balance of payments positon.
4 Revised expectations by citizens
With economic growth citizens may alter their expectations of government and expect more services from the state e.g. revised taxes, wage demands and investment.
5 Uneven distribution of wealth
If the increase in wealth is not fairly distributed then the gap between rich and poor may widen.
(C) (i) Discuss three factors currently influencing the rate of savings in the Irish economy.
(3 points at 5 marks each – 15 marks)

Sample Answer C (i)

1 Future Expectations for the economy
If people are concerned about the future of the economy, it will affect consumer confidence. As a result people will tend to postpone purchasing and save instead.
2 Security of savings
If people don’t have confidence in the banking system, they will withdraw their deposits and move them outside the country or to government backed schemes.
3 Price Levels / Real rate of Interest
If deflation is present it means that people need to spend less to buy goods and services and so the ability to save money increases. Deflation increases the real rate of return on savings as the value of inflation is negative ( real rate of return = nominal rate of return – inflation )
4 Quality of Financial Products
Due to the banking crisis consumers are seeking greater security for their savings e.g. An Posts savings bonds.
5 Differed Spending
If unemployment is rising people are likely to reduce spending and increase savings.
6 Future Levels of state benefits
If people are fearful for their future they need to increase savings or pension contributions so that they can afford a comfortable senior life.
(C) (ii) Outline three economic effects which an increase in the rate of savings may have on the Irish economy.
(3 points at 5 marks each = 15 marks (state 2 marks, explain 3 marks))

Sample Answer C (ii)

1 Reduced spending within the economy / leakage from the circular flow of income
People who save more spend less and so the demand for goods and services may fall.
2 Increase in unemployment
Falling demand for goods and services will result in reduction for labour resulting in increased unemployment.
3 More funds available for investment
Increased savings will mean that more funds are available in financial institutions for borrowing by individuals and businesses. This may help economic growth.
4 Reduced demand for imports
Less spending may mean reduced demand for imports thereby helping to improve our Balance of Payments.
5 Stabilise banking sector
Increased savings result in increased funds available to banks. This may lead to increased stability in the banking sector at a time when confidence needs to be restored.
6 Increased revenue for Government
More savings mean increased revenue from DIRT to the government.