calculation of effect of changing AD on national income using the multiplier

The Circular Flow of Income

Imagine a big pizza 🍕 that everyone in the economy shares. The circular flow shows how that pizza moves between households and firms, just like a game of passing a ball around a circle. Each round of the game changes the amount of pizza (income) everyone gets.

Key Parts of the Flow

• Households: They provide labour and consume goods.
• Firms: They produce goods and pay wages to households.
• Government & Foreign Sector: They add or take out money through taxes, spending, exports, and imports.

What is Aggregate Demand (AD)?

AD is the total amount of goods and services that households, firms, the government, and foreigners want to buy at a given price level. Think of it as the total “pizza demand” in our game.

How AD Changes the Circular Flow

When AD goes up, firms need more pizza to satisfy the higher demand. They hire more workers, pay more wages, and the extra income circulates back to households, who then spend more. This creates a chain reaction that amplifies the initial change in AD.

The Multiplier Effect

The multiplier tells us how much total national income (Y) will change when AD changes. It depends on the Marginal Propensity to Consume (MPC), the fraction of extra income that households spend.

The formula is:

$$\Delta Y = \frac{1}{1 - MPC} \times \Delta AD$$

Step‑by‑Step Example

1. Assume the MPC is 0.8 (people spend 80% of extra income).
2. Government increases AD by $100 million.
3. Calculate the multiplier:
   • Multiplier = $1/(1-0.8) = 5$
4. Find the change in national income:
   • $\Delta Y = 5 \times 100 = 500$ million
5. Result: National income rises by $500 million because of the $100 million increase in AD.

Quick Reference Table

🎉 Remember: The higher the MPC, the bigger the multiplier, and the more powerful the ripple effect of an AD change in the circular flow! Keep practicing with different MPC values to see how the outcome changes.