10 - How the Macroeconomic Work: Circular Flow and Aggregate Demand/Supply Flashcards
What is National Income and how can it be measured
National income is the total value of the goods and services a country produces. It is the output in one year.
It can be measured by GDP, GNP and GNI.
What is the real GDP?
Real GDP is the value of GDP adjusted for inflation. For example, if the economy grew by 4% since last year, but inflation was 2%, real economic growth was 2%.
What is the Nominal GDP?
- Nominal GDP is the value of GDP without being adjusted for inflation
- This can be misleading as it doesn’t show the real growth of GDP
What is the difference between nominal and real income?
Nominal income is the total amount of money a person earns in a given period of time, while real income is the nominal income adjusted for inflation.
What is Gross National Product (GNP)?
Gross National Product (GNP) is the market value of all products produced in an annum by the labour and property supplied by the citizens of one country
What is the Gross National Income (GNI)?
Gross National Income (GNI) is the total amount of money earned by a nations people and businesses in a given period (usually a year)
What are the three methods of measuring the flow of new output?
- The income approach
- The output approach (goods and services)
- The expenditure approach, C+I+G+(X-M)
Difference between a closed and open economy?
Closed - An economy with no international trade
Open - an economy open to international trade
Draw the circular flow of income diagram?
Explain this diagram?
Firms and households interact and exchange resources in an economy.
Households supply firms with the factors of production, such as labour and capital, and in return, they receive wages and dividends.
Firms supply goods and services to households. Consumers pay firms for these.
This spending and income circulates around the economy in the circular flow of income, which is represented in the diagram above.
What is savings?
Income which is not spent
What is withdrawal?
A leakage of spending power out of the circular flow of income into savings, taxation or imports.
What is investment?
Total planned spending by firms on capital goods produced within the economy.
What is injection?
Spending entering the circular flow of income as a result of investment, government spending and exports.
Explain the withdrawals and saving in this diagram?
Saving income removes it from the circular flow. This is a withdrawal of income.
Taxes are also a withdrawal of income, whilst government spending on public and merit goods, and welfare payments, are injections into the economy.
International trade is also included in the circular flow of income. Exports are an injection into the economy, since goods and services are sold to foreign countries and revenue in earned from the sale. Imports are a withdrawal from the economy, since money leaves the country when goods and services are bought from abroad.
How can real National income be an indicator of economic performance?
- The level of real national income is an indicator of current living standards within the economy
- It’s rate of change measures the economic growth (or decline) occurring in the economy
- The level and rate of change of real national income are used when comparing the country’s economic performance with that of other countries
What is full employment income?
The level of income when the economy is producing on its production possibility frontier, with no spare capacity.
When does the equilibrium National income occur?
The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections.
Aggregate demand = aggregate supply
What is key to remember in this diagram?
Income = expenditure =output.
What is the relationship between saving and investments in the economy?
The amount of savings in an economy is equal to the amount of investment. In the UK, there is a traditionally low savings rate, especially during periods of high economic growth, and this means that the rate of investment is also low. In Japan there is a high savings rate and with this comes a high level of investment.
What happens if Savings + Taxation + Imports < Investment + Government spending + Exports?
If there are net injections into the economy, there will be an expansion of national output (national income).
What happens if Savings + Taxation + Imports > Investment + Government spending + Exports?
If there are net withdrawals from the economy, there will be a contraction of production, so output (National income) decreases.
What is aggregate demand?
Aggregate demand is the total amount of goods and services demanded in the economy at a given time and price level.
AD = C + I + G + (X - M)
What are reflationary policies?
Policies that increase aggregate demand with the intention of increasing real output and employment
What is aggregate supply?
Aggregate supply measure the volume of goods and services produced each year.
The level of real national output that producers are prepared to supply at different average price levels
Draw an aggregate demand (AD) curve?
.
What does the graph show as you move along the AD curve?
- A fall in the price level from P1 to P2 causes an expansion in demand from Y1 to Y2
- A rise in the price level from P2 to P1 causes a contraction in demand from Y2 to Y1
- Changes in the price level cause movements along the demand curve.
How can the downward slope of the AD curve be explained by? (3 reasons)
- Higher prices lead to a fall in the value of real incomes, so goods and services become less affordable in real terms.
- If there was high inflation in the UK so that the average price level was high, foreign goods would seem relatively cheaper. Therefore, there would be more imports, so the deficit on the current account might increase, and AD would fall.
- High inflation generally means the interest rates will be higher. This will discourage spending, since saving becomes more attractive and borrowing becomes expensive.
Draw a shifted AD curve?
(Physics and maths)
How does the AD curve shift?
It is shifted by changes in the components of AD (C, I, G or X-M)
How is a rise in AD shown in a graph?
By a shift to the right in the demand curve (AD1 -> AD2)
How does a rise in economic growth occur when its related to a rise in AD shown by a shift to the right in the demand curve?
- Consumers and firms have higher confidence levels, so they invest and spend more, because they feel as though they will get a higher return on them. This is affected by anticipated income and inflation
- Lower taxes mean consumers have more disposable income, so AD rises
- An increase in government spending will boost AD
- Depreciation in a currency means imports is more expensive, and exports is cheaper, so AD increases
- In the UK, most people own their houses. This means that a rise in the price of houses makes people feel wealthier, so they are likely to spend more. This is the wealth effect.
- If credit is more available, then spending and investment might increase. Recently, since the financial crisis of 2008, banks have been less willing to lend due to the risks associated with lending.
Draw an aggregate supply (AS) curve diagram?
(Textbook)
Why is the AS curve upward sloping?
Because at a higher price level, producers are willing to supply more because they can earn more profits.
What leads to movements along the AS curve?
- Changes in the price level, which occur due to changes in AD, lead to movements along the AS curve
- If AD increases, there is an expansion in the SRAS, from Y1 to Y2. If AD falls, there is a contraction in SRAS, from Y1 to Y3.
Draw a shifted SRAS curve?
(physics and maths)
When does the SRAS curve shift and what might make this occur?
When there are changes in the conditions of supply:
- The cost of employment might change, e.g. wages, taxes, labour
productivity
- The cost of other inputs e.g. raw materials, commodity prices, the
exchange rate if products are imported
- Government regulation or intervention, such as environmental laws
and taxes, and business regulation. Business regulation is sometimes called ‘red tape’.
What does the SRAS curve show and only cover?
- It only covers the period immediately after a change in the price level
- It shows the planned output of an economy when prices change, whilst the cost of production and productivity of the factor inputs are kept constant. E.g. wage rates or how technologically advanced capital is
Why is the SRAS curve upward sloping?
Because supply is assumed to be responsive to a change in AD, which is reflected in the price level.
What is long run aggregate supply curve (LRAS)?
- It shows the potential supply of an economy in the long run
- This is when prices, and the costs and productivity of factor inputs, can change
- Similarly to the PPF, it can show the economy’s productive potential
What way is the LRAS curve positioned and why?
- Vertically
- because supply is assumed not to change as the price level changes.
The LRAS is vertical because, in the long-run, the potential output an economy can produce isn’t related to the price level. There are only two things that matter for potential output: 1) the quantity and the quality of a country’s resources, and 2) how it can combine those resources to produce aggregate output.
Draw the LRAS curve?
(physics and maths)
What does a right-ward shift in the LRAS curve show?
Economic growth
When does the economy reach a state of equilibrium national income (or macroeconomic equilibrium)?
- When the rate of withdrawals = the rate of injections
- This is equivalent to the point where AD = AS.
Draw a graph where equilibrium national income occurs when AD = AS?
.
What happens at a price above equilibrium and at a price below?
- A price above = there will be excess supply
- A price below = there will be excess aggregate demand, in the short run
What is an economic shock?
An unexpected event hitting the economy. Economic shocks can be demand-side or supply-side shocks and unfavourable or favourable
Draw a shift in AS (supply side) curve when it experiences a shock affecting the macroeconomy?
(physics and maths)
In a shift in AS curve diagram why would it shift to the right and why would it shift to the left?
- If the economy becomes more productive, or if there is an increase in efficiency, supply will shift to the right. This lowers the average price level (Pe to P1) and increases national output (Ye to Y1)
- If AS shifts inwards, price increases and national output decreases.
Draw a shift in AD curve when it experiences a shock affecting the macroeconomy?
What may cause the AD curve to shift inwards?
If firms have less confidence or there is a recession. This causes the price level to fall from Pe to P1, and national output to fall from Ye to Y1
What does aggregate demand measure?
Spending on goods and services by consumers, firms, the government and overseas consumers and firms.