Circular flow of income: two-sector model

A low marginal propensity to consume means that households spend only a small part of each additional unit of income and save a relatively large part. Saving is a leakage from the circular flow because it temporarily withdraws expenditure from the consumption stream. Therefore, after investment increases, saving can quickly weaken repeated rounds of spending and reduce the multiplier effect.

If firms produce more while planned expenditure remains unchanged, buyers do not purchase the entire additional output. The unsold goods accumulate as unintended inventories, so actual inventories rise. Firms interpret this as a signal of excess production and may reduce output in a later adjustment period until production is consistent with planned expenditure.

When planned expenditure exceeds current output, firms experience an unintended fall in inventories and receive a signal to expand production. Higher production may require more labour and other factor services. Payments to these factors, such as wages, rent, interest, and profit, can therefore increase household income. The increase is possible rather than guaranteed in every situation.

In a simple two-sector economy, disposable income is divided between consumption and saving, so Y = C + S. If the saving function shifts upward, households save more at each given income level. With income unchanged, the amount available for consumption is lower; therefore, the consumption function generally shifts downward by the corresponding amount, assuming no other change.

An upward shift of the consumption function means that households plan to consume more at every level of income. This raises autonomous consumption and planned expenditure. Firms respond to stronger demand by increasing output and factor payments. The resulting income creates further consumption, so the multiplier process can raise equilibrium income, provided the marginal propensity to consume is positive and less than one.

The product, income, and expenditure methods examine the same economic activity from three viewpoints. The value of final output creates income for the factors of production, and that income is spent on goods and services. Therefore, when inventories, depreciation, imports, exports, taxes, and other adjustments are handled correctly, total output, total income, and total expenditure are theoretically equal.