Pre-amble: Singapore’s standing as a trusted hub for business and a critical global supply chain node has helped to attract a record $22.5 billion in foreign direct investments (FDI) driven by the electronics sector.

a) Using the circular flow of income model, explain how investments lead to a multiplied increase in national income. (MI 2024 Prelims Q5)

Introduction

The circular flow of income illustrates the movement of goods, services, and payments throughout an economy. It shows how different economic units (households, firms, government, and the foreign sector) interact, leading to equilibrium in output, income, and expenditure.

R1: Explain How the Circular Flow of Income determine the Equilibrium Level of National Income

With reference to the figure below, firms pay wages to households to use their production factors (land, labor, capital, and entrepreneurship). Households, in turn, use their factor income to purchase domestically produced goods and services from firms. In a four-sector economy, some of this income leaks out of the circular flow in the form of savings to banks (S), taxes paid to the government (T), and expenditure on imports (M). These are collectively known as withdrawals (W) from the circular flow of income. In addition to household spending, demand for a firm's output comes from other economic sectors, including businesses, the government, and foreign buyers. These contributions are known as injections (J) into the circular flow of income. Injections represent domestic firms' income that does not originate from household consumption. Specifically, injections include investment (I), where firms spend on capital goods, government expenditure (G) on public services and infrastructure, and exports (X), which generate income from selling goods and services to foreign markets.

*Fig.1 Circular Flow of Income Diagram.*

In a four-sector economy, equilibrium national income is achieved when total withdrawals equal total injections, i.e., W (savings + taxes + imports) = J (investment + government spending + exports). At this equilibrium, current spending matches current national output, ensuring no depletion or accumulation of inventories, which leaves firms with no reason to adjust their production levels.

R2: Explain how investments lead to a multiplied increase in national income via the multiplier process

Investment is a component of aggregate demand (AD) that refers to the spending by firms on capital goods such as machinery and factories. Since firms borrow money from banks to purchase capital goods from other firms, money is injected into the circular flow of income via an increase in I. Suppose a four-sector economy with excess capacity, an injection of $100 million in export expenditure would initially generate a $100 million increase in household income for employees of the firms. Assuming MPC = 0.5, households will spend $50 million on induced consumption, while the other $50 million is leaked into savings, taxes, or imports. This induced consumption generates further income for other groups supplying the consumer goods. They, too, will spend based on their MPC, inducing an additional $25 million in the next round while $25 million is leaked from the circular flow of income. This cycle continues until J = W, where the total increase in leakages equals the initial injection of $100 million. Each successive round of induced consumption becomes smaller due to continuous leakages into savings, taxes, or imports (S + T + M).

A rise in investment expenditure will lead to an increase in aggregate demand (AD), since AD = C + I + G + (X-M), thus shifting the AD curve by a larger extent from AD0 to AD1 and to AD2. The final equilibrium income rises from Y0 to Y2.

The multiplier effect eventually leads to a total increase in national income larger than the initial injection and the extent of the rise in national income depends on the size of the multiplier, k. In this case, since k is 2 which is derived from the calculation k = 1/(MPS + MPT + MPM), the total rise in national income is $200 million.

Conclusion

Hence, investment expenditure will lead to a multiplied rise in national income, due to the knock-on effect of higher consumer spending induced by higher incomes.

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JAN ESSAY RELEASE: Circular Flow of income