Circular flow of income: two-sector model

In a simple two-sector model, the investment multiplier is k = 1/MPS, or equivalently k = 1/(1 − MPC). When MPS rises, households save a larger share of each additional unit of income, so less is spent in each successive round. The multiplier therefore falls. Hence, option A is correct.

A higher MPC means that households spend a larger proportion of any additional income and save a smaller proportion. Consequently, each round of induced consumption is larger, so the multiplier k = 1/(1 − MPC) increases. A given rise in investment therefore produces a stronger increase in total income. Option B is correct.

In the two-sector model, the investment multiplier is k = 1/(1 − MPC). With MPC = 0.5, k = 1/(1 − 0.5) = 2. The total change in income is therefore ΔY = k × ΔI = 2 × 20 = 40. Thus, option C is correct. The amount 20 is only the initial increase in investment; the additional rounds of consumption generate the larger total increase in income.

In the two-sector model, saving is a planned leakage and investment is a planned injection. Income remains in equilibrium when planned leakage equals planned injection, so planned saving equals planned investment: S = I. At this point, there is no unplanned change in inventories caused by a demand imbalance. Therefore, option A is correct.

Unplanned inventory accumulation occurs when firms produce more goods than buyers purchase at the expected level of demand. The unsold output remains in firms’ stocks and is recorded as unplanned investment. It therefore signals that actual product demand was lower than expected, or that aggregate expenditure was insufficient to buy the planned output. Option A is correct.

Unplanned inventory depletion means that firms sold more of their finished goods than they had expected. Actual demand and sales were therefore higher than anticipated, causing stocks to fall unexpectedly. This situation may encourage firms to raise production or planned inventories in the next period. It is not evidence that saving was zero or that output exceeded demand, so option B is correct.

In a simple two-sector economy, household saving is treated as a leakage because it is not spent on current consumption, while firms’ investment is an injection because it adds expenditure to the circular flow. When all saving is matched by investment, S = I, total leakages equal total injections, and planned expenditure remains balanced. This is the equilibrium condition; it does not mean that consumption is zero.

Households own or supply the factors of production—labour, land, capital and entrepreneurship—to firms. The productive services of these factors move from households to firms and constitute a real flow. In return, firms make factor payments such as wages, rent, interest and profit; those payments are a money flow from firms to households. Goods and services generally move in the opposite real-flow direction, from firms to households.

In a two-sector income-determination model, equilibrium occurs when planned aggregate expenditure equals output. Since household saving is the leakage and planned investment is the injection, the equivalent equilibrium condition is planned S = planned I. At this point, firms have no reason to make unintended inventory adjustments. Consumption need not equal investment, and households need not consume all their income; positive saving can exist at equilibrium.

Disposable income is divided between consumption and saving, so S = Y − C. Substituting C = 20 + 0.75Y gives S = Y − (20 + 0.75Y) = −20 + 0.25Y. Therefore autonomous saving is −20 and the marginal propensity to save is 1 − 0.75 = 0.25. Negative autonomous saving means households dissave when income is zero; it does not make the calculation invalid.

The expenditure identity for a two-sector economy is Y = C + I, where households and firms are the only sectors considered. C represents consumption expenditure by households, and I represents investment expenditure, normally private investment undertaken by firms. Imports, taxes and government expenditure belong to identities for more extended models containing the foreign or government sector. Therefore option B is correct.

In the two-sector expenditure identity, income is determined by consumption plus investment: Y = C + I. If investment falls while consumption is unchanged, planned aggregate expenditure falls directly. Firms consequently face weaker demand and reduce production and income, at least initially. Through the multiplier process, the eventual decrease in equilibrium income may be larger than the initial fall in investment, provided the marginal propensity to consume is positive.

The two-sector model contains households and firms, but no government or foreign sector. Autonomous investment is an expenditure that does not depend on current income, so its increase raises planned aggregate expenditure directly. Firms respond to stronger demand by increasing production and income. The higher income then causes households to increase consumption according to their marginal propensity to consume, producing successive rounds of spending and a multiplier effect. Thus A gives the correct sequence.

In a closed two-sector economy, saving is a leakage because it is not immediately used to purchase current output, while investment is an injection into the spending stream. Stable equilibrium occurs when the leakage is exactly matched by the injection. Therefore planned saving must equal planned investment, or S = I. If saving exceeds investment, planned expenditure is insufficient and firms accumulate inventories; if investment exceeds saving, expenditure and income tend to rise.

Autonomous consumption is the part of consumption that does not depend on current income. When it rises, households plan to spend more at every possible level of income. This shifts the consumption and aggregate-expenditure schedules upward. With investment and the marginal propensity to consume unchanged, firms experience greater demand, increase production, and generate higher income. The multiplier can make the final rise in equilibrium income larger than the initial increase in autonomous consumption.

When expected sales exceed actual sales, firms sell less than they planned. The unsold output remains as an unintended increase in inventories. This accumulation signals that current production is greater than the demand actually realized. To correct the imbalance, firms are likely to reduce production in the next period, although the exact size of the adjustment depends on their inventory policy and expectations. A definite doubling of output is not implied by the information given.

When actual sales exceed expected sales, firms have sold more than they planned at the existing level of output. Their inventories therefore fall unexpectedly, which indicates that market demand is stronger than anticipated. To restore inventories and meet the higher observed demand, firms are likely to increase production in the next period. The decision is described as a direction or tendency, not necessarily a doubling of output or an immediate shutdown.

A rise in product-market demand encourages firms to expand production when they have capacity and labour available. Producing more output generally requires firms to employ more labour or offer more hours of work. This raises the demand for labour in the factor market and can increase total wage payments. The result is not caused by government wage payments, imports or zero saving; those options either introduce excluded sectors or confuse a different circular-flow relationship.

Total factor income is the sum of payments to all factors of production: wages for labour, rent for land, interest for capital, and profit for entrepreneurship. Therefore, an increase in wages does not by itself prove that total factor income has increased. The decreases in rent and interest, together with any change in profit, must also be considered before judging the net effect.

Factor payments are received as money income, so their increase may be only nominal. Real purchasing power depends on how much goods and services that income can buy after allowing for the price level. If prices rise as fast as, or faster than, factor payments, households may experience no improvement or even a fall in real purchasing power.

Money flow is measured in current monetary terms and can increase merely because prices have risen. If real output remains unchanged, the economy has not necessarily produced more goods and services. The analyst must therefore separate price effects from quantity effects, using real measures or constant prices where appropriate, instead of interpreting every monetary increase as genuine production growth.

Household saving is a leakage because it represents income that is not immediately spent on firms’ goods and services. When banks do not channel the saved funds into loans for investment, the money does not return to firms as equivalent expenditure. Consequently, consumption demand and the circular flow may weaken. Investment is an injection only when funds are actually used for investment.

Financial intermediation occurs when financial institutions, such as banks, connect households that save with firms or other borrowers that need funds. Banks collect deposits, assess borrowers, and provide loans for productive uses such as investment. In this way, household saving can be converted into business investment and returned to the circular flow as expenditure, although the saving itself is initially a leakage.

In a two-sector economy, disposable income is divided between consumption and saving, so S = Y − C. Substituting the given values gives S = 250 − 190 = 60. At equilibrium, planned saving equals planned investment, or S = I. Therefore, investment must be 60, making option C correct. The other numerical choices do not satisfy the equilibrium condition.

Saving is defined as income minus consumption: S = Y − C. Substituting C = 80 + 0.6Y gives S = Y − (80 + 0.6Y) = −80 + 0.4Y. The constant term becomes negative autonomous saving, and the coefficient of income is the marginal propensity to save, 1 − 0.6 = 0.4. Therefore, option D is correct.