The Interrelationships Between Income, Consumption and Investment

The Interrelationships Between Income, Consumption and Investment
The diagram above is a simplified version of an economy. In this example households own factor services which they hire out to firms. The firms then use factor services to manufacture goods and services. Households receive income for their services which is used to consume the output of firms; the initial relationship between income and consumption. In this diagram then the world would be a happy place; full employment, what is produced is consumed, no overproduction leading to deflation, no underproduction leading to inflation. However, it is not that simple. As the diagram shows there are withdrawals, these come in the shape of money saved by households, taxation and money spent on imports. With only withdrawals, there would be mass deflation; there would be less money in the economy and as a result demand and supply would push prices down.
If we take the example of a bath of water, the water being the price level. With the plug pulled out (withdrawals) water drains from the bath and lowers the water level (price level). The person in the bath, we?ll call him John sees there is less water to wash with and as a result has to make the water he has go further, much the same as the lesser amount of money in the economy is made to do ? deflation. This is where injections come in. These take the form of investment in capital, government spending and revenue from exports. These counterbalance any flows out of the economy. In the bath example, these injections would be John turning on the tap and replacing lost water (money) whereby resulting in a state of equilibrium, order is once again returned to the happy place the world is. Now we come to the relationship between investment and income. When there is an increase in injections, part of it will be received through the circular flow by households as extra income. Households can do several things with this extra income. The can spend it all, save it all, or the more likely; save some and spend some. The proportion a household does of each is dependant upon what is known as their marginal propensity to save (mps) and their marginal propensity to consume (mpc). This is usually represented as a decimal of 1, the two will always add up to 1 as what is not spent is saved and what is not saved is spent. As an example, John is a fireman. He is paid an annual salary of £20,000. Due to the recent protests over low pay, John is given an increase in his annual salary of £1,000 ? a 5% increase. John is however by no means rich. A lot of this increase is spent on bills and raising the standard of living for his family. A small proportion is however saved. John saves £200 ? 20% of the increase in salary. He has therefore consumed 80% and saved 20% which can be represented as 0.8 spent and 0.2 saved. His mpc is therefore 0.8 and his mps 0.2. From this we could say that if he were to receive an increase in salary of £10,000 instead of the £1,000, he would spend £8,000 and save £2,000. It is likely however that more of the increase in income would be saved rather than spent, the larger the increase in income. The reason being that there is a limit to the amount John wants to improve his standard of living, he may be content with changing from Sommerfield own brand baked beans to Heinz baked beans, rather than paying more for Harrods own brand baked beans. Anyway, John has a salary increase; he spends more now, whereby increasing consumption. Whatever John spends this increase in salary on is the income of those who sell him the products. They in turn will spend some of the money they receive. Some of this income will be spent and some will leak out of the circular flow. Spending will continue to increase until leakages match the initial injection. This is known as the multiplier effect. The multiplier is measured in figures; a multiplier of 3 would mean that an injection of £2 million would cause aggregate demand to rise by £6 million. The size of the UK multiplier is thought to be 1.33. Therefore we can see by looking at the circular flow that an increase in investment in firms will result in an increased demand for factors of production from households. This will mean increased income for households to consume more products from firms. In this instance, increased investment has caused increased income which has caused increased consumption. The relationship between investment and income also works inversely; the level of net investment will be determined by the rate of change of national income. If national income is growing at an increasing rate then net investment will also grow. The accelerator theory is largely based on the assumption of a stable capital to output ratio, and that demand for capital comes from the demand for final goods and services. If expected demand is greater than a firm?s productive capacity, then additional capital may be needed. Thus investment is a function of the rate of change in national income. John has a brother called Jack. Jack owns a computer manufacturing business. He sees that national income has increased and expects demand for computers to increase as a result. Jack decides to invest in capital so as to increase his firm?s productive capacity in line with the expected increase in demand. Therefore, the increase in national income has resulted in There will then be an interaction between the multiplier and the accelerator that may cause larger fluctuations in the trade cycle.

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