National Income, Circular Flow, Consumption and Investment
This domain covers measurement of national income, the circular flow with injections and leakages, and the multiplier. Expect questions that require computing equilibrium income and distinguishing GDP from GNP and real from nominal values.
Measuring national income
- GDP is output produced within a country's borders; GNP, or GNI, adds net factor income from abroad.
- Three equivalent methods: expenditure, income, and output or value added. The expenditure identity is GDP equals consumption plus investment plus government spending plus exports minus imports.
- Real GDP is corrected for inflation using the GDP deflator; nominal GDP can rise while output stagnates. Per capita figures should be compared in purchasing power parity terms.
- Excluded from GDP: transfer payments such as pensions, second-hand sales, intermediate goods, and most subsistence output, which matters greatly in Cameroon.
Circular flow
- Households supply factors and receive incomes; firms produce. Injections are investment, government spending and exports; leakages are saving, taxation and imports.
- Equilibrium occurs where planned injections equal planned leakages.
- The multiplier is one divided by one minus the marginal propensity to consume, or by the sum of marginal propensities to save, tax and import. The accelerator links investment to changes in output.
Consumption and investment
- Consumption function: C equals autonomous consumption plus the marginal propensity to consume times income. Average propensity to consume falls as income rises.
- Investment depends on interest rates, expectations, technology and capacity utilisation; the paradox of thrift shows higher saving can lower equilibrium income.
Worked example
C = 200 + 0.75Y, I = 300, G = 250, X = 200, M = 0.15Y, all in billions of XAF.
- Y = 200 + 0.75Y + 300 + 250 + 200 - 0.15Y.
- Y - 0.60Y = 950, so 0.40Y = 950 and equilibrium Y = 2,375 billion XAF.
- The multiplier is 1 divided by 0.40, which is 2.5; an extra 40 billion XAF of investment raises income by 100 billion.
Traps that cost marks
- Counting pensions or student grants as government spending in GDP.
- Double counting intermediate goods instead of using value added.
- Reading a rise in nominal GDP as growth when prices rose.
- Using the simple multiplier when taxes and imports exist, which overstates the effect.
- Confusing GNP with GDP when factor income crosses borders.