Question

3. Based on the circular flow/inner-tube model, all of the leakage variables (leakages from the spending stream) are or can be tied to income as a positive function. (Hint: You might consult Models and Multipliers, Models I, Ill, and V for guidance here.)

Question: For each leakage, saving, imports, and taxes

a) How does an increase in the volume of each affect the income level

b) How will an increase in the coefficient linking it to income affect the size of multipliers? [coefficient being MPS, tax rate, MPM]

Answer 1

(a) Any leakage will decrease the income level. Therefore, if either saving, imports or tax increases, income level will decrease.

(b) Multiplier = 1 / [1 - {MPC x (1 - Tax rate)} + MPM] = 1 / [1 - {(1 - MPS) x (1 - tax rate)} + MPM]

(i) If MPS increases, (1 - MPS) decreases, {(1 - MPS) x (1 - tax rate)} decreases, [1 - {(1 - MPS) x (1 - tax rate)} + MPM] increases and therefore, Multiplier decreases.

(ii) If tax rate increases, (1 - tax rate) decreases, {(1 - MPS) x (1 - tax rate)} decreases, [1 - {(1 - MPS) x (1 - tax rate)} + MPM] increases and therefore, Multiplier decreases.

(iii) If MPM increases, [1 - {(1 - MPS) x (1 - tax rate)} + MPM] increases, therefore multiplier decreases.