10 - How the Macroeconomic Work: Circular Flow and Aggregate Demand/Supply Flashcards
(131 cards)
1
Q
What is National Income and how can it be measured
A
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.
2
Q
What is the real GDP?
A
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%.
3
Q
What is the Nominal GDP?
A
- 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
4
Q
What is the difference between nominal and real income?
A
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.
5
Q
What is Gross National Product (GNP)?
A
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
6
Q
What is the Gross National Income (GNI)?
A
Gross National Income (GNI) is the total amount of money earned by a nations people and businesses in a given period (usually a year)
7
Q
What are the three methods of measuring the flow of new output?
A
- The income approach
- The output approach (goods and services)
- The expenditure approach, C+I+G+(X-M)
8
Q
Difference between a closed and open economy?
A
Closed - An economy with no international trade
Open - an economy open to international trade
9
Q
Draw the circular flow of income diagram?
A
10
Q
Explain this diagram?
A
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.
11
Q
What is savings?
A
Income which is not spent
12
Q
What is withdrawal?
A
A leakage of spending power out of the circular flow of income into savings, taxation or imports.
13
Q
What is investment?
A
Total planned spending by firms on capital goods produced within the economy.
14
Q
What is injection?
A
Spending entering the circular flow of income as a result of investment, government spending and exports.
15
Q
Explain the withdrawals and saving in this diagram?
A
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.
16
Q
How can real National income be an indicator of economic performance?
A
- 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
17
Q
What is full employment income?
A
The level of income when the economy is producing on its production possibility frontier, with no spare capacity.
18
Q
When does the equilibrium National income occur?
A
The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections.
Aggregate demand = aggregate supply
19
Q
What is key to remember in this diagram?
A
Income = expenditure =output.
20
Q
What is the relationship between saving and investments in the economy?
A
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.
21
Q
What happens if Savings + Taxation + Imports < Investment + Government spending + Exports?
A
If there are net injections into the economy, there will be an expansion of national output (national income).
22
Q
What happens if Savings + Taxation + Imports > Investment + Government spending + Exports?
A
If there are net withdrawals from the economy, there will be a contraction of production, so output (National income) decreases.
23
Q
What is aggregate demand?
A
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)
24
Q
What are reflationary policies?
A
Policies that increase aggregate demand with the intention of increasing real output and employment
25
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
26
Draw an aggregate demand (AD) curve?
.
27
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.
28
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.
29
Draw a shifted AD curve?
(Physics and maths)
30
How does the AD curve shift?
It is shifted by changes in the components of AD (C, I, G or X-M)
31
How is a rise in AD shown in a graph?
By a shift to the right in the demand curve (AD1 -> AD2)
32
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.
33
Draw an aggregate supply (AS) curve diagram?
(Textbook)
34
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.
35
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.
36
Draw a shifted SRAS curve?
(physics and maths)
37
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’.
38
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
39
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.
40
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
41
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.
42
Draw the LRAS curve?
(physics and maths)
43
What does a right-ward shift in the LRAS curve show?
Economic growth
44
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.
45
Draw a graph where equilibrium national income occurs when AD = AS?
.
46
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
47
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
48
Draw a shift in AS (supply side) curve when it experiences a shock affecting the macroeconomy?
(physics and maths)
49
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.
50
Draw a shift in AD curve when it experiences a shock affecting the macroeconomy?
51
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
52
What does aggregate demand measure?
Spending on goods and services by consumers, firms, the government and overseas consumers and firms.
53
What're the components that makes up aggregate demand and the equation for it?
C + I + G +(X-M)
54
What does each letter stand for in C + I + G +(X-M)?
- C = Consumer spending/expenditure
- I = Investment
- G = Government
- X = Exports
- M = Imports
55
What is consumer spending?
- How much consumers spend on goods and services
- This is the largest component of AD and is therefore most significant to economic growth
56
What is disposable income?
The amount of income consumers have left over after taxes and social security charges have been removed. It is what consumers can choose to spend.
57
Where might consumer income come from?
Wages, savings, pensions, benefits and investments, such as dividend payments
58
What is a consumer's ‘marginal propensity to consume' (MPC)?
How much a consumer changes their spending following a change in income
59
What is a consumer's ‘marginal propensity to save' (MPS)?
- The proportion of each additional pound of household income that is used for saving
- If consumers save more than they spend, the size of the multiplier will be small.
60
What are the influences on consumer spending?
- Interest rates
- Consumer confidence
61
How are interest rates a influence on consumer spending?
- If the Monetary Policy Committee lowers interest rates, it is cheaper to borrow and reduces the incentive to save, so spending and investment increase
- Lower interest rates lower the cost of debt, such as mortgages. This increases the effective disposable income of households
62
How is consumer confidence a influence on consumer spending?
- 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.
- If consumers fear unemployment or higher taxes, consumers may feel less confident about the economy, so they are likely to spend less and save more. This delays large purchases, such as houses or cars.
63
What is capital investment (component of AD)?
- The expenditure of money to fund a company's long-term growth
- This accounts for around 15-20% of GDP in the UK per annum, and about 3⁄4 of this comes from private sector firms
- The other 1⁄4 is spent by the government on, for example, new schools
- This is the smallest component of AD.
64
What are the influences on investment?
- The rate of economic growth
- Business expectations and confidence
- Demand for exports
- Interest rates
- Access to credit
- The influence of government and regulations
65
How is 'the rate of economic growth' an influence on investment?
- If growth is high, firms will be making more revenue due to higher rates of consumer spending
- Meaning they have more profits available to invest
66
How is 'business expectations and confidence' an influence on investment?
- If firms expect a high rate of return, they will invest more. Firms need to be certain about the future, otherwise they will postpone their investments.
- Expectations about society and politics could affect investment. E.g., if a change in government might happen, or if commodity prices are due to rise, businesses may postpone their investment decisions.
- Keynes coined the term animal spirits when describing instincts and emotions of human behaviour, which drives the level of confidence in an economy
67
How is 'demand for exports' an influence on investment?
- This is related to the rate of market demand. The higher demand is, the more likely it is that firms will invest.
- This is because they expect higher sales, so they might direct capital goods into the markets where consumer demand is increasing.
68
How are 'interest rates' an influence on investment?
- Investment increases as interest rates falls. This means that the cost of borrowing is less and the return to lending is higher
- The higher interest rates are, the greater the opportunity cost of not saving the money
- High interest rates might make firms expect a fall in consumer spending, which is likely to discourage investment
69
What is access/availability to credit?
Funds available for households and firms to borrow
70
How is 'access to credit' an influence on investment?
- If banks and lenders are unwilling to lend, such as shortly after the financial crisis when banks became more risk averse, firms will find it harder to gain access to credit, so it is either more expensive or not possible to gain the funds for investment.
- Firms could use retained profits, however
- The availability of funds is dependent on the level of saving in the economy.
The more consumers are saving, the more available fund are for lending, and therefore for investing
71
How is 'the influence of government and regulations' an influence on investment?
The rate of corporation tax could affect investment. Lower taxes means firms keep more profits, which could encourage investment.
72
What does the accelerator effect suggest?
-That the level of investment in an economy is related to the change in GDP
- A higher rate of economic growth causes more investment.
73
What is the accelerator process?
The basic accelerator process is an economic theory that states that when there is increased demand for a product or service, companies will invest more money to meet that demand
Size of accelerator depends on economy’s output and capital ration
This leads to higher production, more jobs, and more income for individuals, which further stimulates demand.
74
What is government spending (component of AD)?
- This is how much the government spends on state goods and services, such as schools and the NHS
- It accounts for 18-20% of GDP. Transfer payments are not included in this figure, because no output is derived from them, and it is simply a transfer of money from one group of people to another
- It's the third largest component of AD
75
What're the influences on government spending/expenditure?
- The trade (business) cycle
- Fiscal policy
76
What is the trade (business) cycle
- Refers to the stage of
economic growth that the economy is in
77
How does the trade cycle have influence on government spending/expenditure?
- The economy goes through periods of booms and busts
- Real output increases when there are periods of economic growth. This is the recovery stage.
- The boom is when economic growth is fast, and it could be inflationary or unsustainable.
- During recessions, there real output in the economy falls, and there is negative economic growth.
- During recessions, governments might increase spending to try and stimulate the economy. This could involve spending on welfare payments to help people who have lost their jobs, or cutting taxes.
- This will increase the government deficit, and they may have to finance this.
- During periods of economic growth, governments may receive more tax revenue
since consumers will be spending more and earning more. They may decide to spend less, since the economy does not need stimulating, and fewer people will be claiming benefits.
78
Draw the trade (business) cycle diagram?
(physics and maths)
79
How does fiscal policy influence government spending/expenditure?
Governments use fiscal policy to influence the economy. It involves changing government spending and taxation.
- Governments might spend on public goods and merit goods, as well as welfare payments.
- Fiscal policy is a demand-side policy, so it works by influencing the level or composition of AD.
- Discretionary fiscal policy
- Automatic stabilisers
- The government might use expansionary fiscal policy during periods of economic decline. This involves increasing spending on transfer payments or on boosting AD, or by reducing taxes.
- During periods of economic growth, governments might use contractionary fiscal policy by decreasing expenditure on purchases and transfer payments. Additionally, tax rates might increase. This reduces the size of the government budget deficit.
80
What is a discretionary policy?
A policy which is implemented through one-off policy changes
81
What are automatic stabilisers?
- Policies which offset fluctuations in the economy. These include transfer payments and taxes. They are triggered without government intervention.
82
What are exports (-) imports (component of AD)?
- The value of the current account on the balance of payments
- A positive value indicates a surplus, whilst a negative value indicates a deficit.
- The UK has a relatively large trade deficit, which reduces the value of AD
- This is the second largest component of AD.
83
What're the main influences on the (net) trade balances (exports (-) imports)?
- Real income
- Exchange rates
- State of the world economy
- Degree of protectionism
- Non-price factors
84
How is real income an influence on the (net) trade balances (exports (-) imports)?
- During periods of economic growth, when consumers have higher incomes and they can afford to consume more, there is a larger deficit on the current account
- When consumers increase their spending, they consume more domestic products as well as more imports
- During periods of economic decline, real incomes fall and historically, this has led to improvements in the UK’s current account
85
How are exchange rates an influence on the (net) trade balances (exports (-) imports)?
- A depreciation of the pound means imports are more expensive, and exports are cheaper, so the current account trade deficit narrows.
- Depreciations make the currency relatively more competitive against other currencies.
- However, it depends on which currency the pound depreciates against. If it is the dollar or euro, it is likely to have a more significant effect, than a currency which is not from one of the UK’s major trading partners.
- The demand for UK exports has to be price elastic to lead to an increase in exports. If demand is price inelastic, exports will not increase significantly, and the value of exports will decrease.
86
How is the state of the world economy an influence on the (net) trade balances (exports (-) imports)?
- A decline in economic growth in one of the UK’s export markets means there will be a fall in exports. This is because consumer spending in those economies will fall, due to falling real incomes
- E.g., the UK’s largest export market is the EU. If they face an economic downturn then demand for UK goods and services will fall, since consumers in the EU are less able to afford imports
87
What is protectionism?
The act of guarding a country’s industries from foreign competition. It can take the form of tariffs, quotas, regulation or embargoes.
88
How is degree of protectionism an influence on the (net) trade balances (exports (-) imports)?
- If the UK employed several protectionist measures, then the trade deficit will
reduce. This is because the UK will be importing less due to tariffs and quotas
on imports to the UK.
- However, since protectionism leads to retaliation, exports might decrease
too, which undoes the effect of reduced imports.
89
How are non-price factors an influence on the (net) trade balances (exports (-) imports)?
- The competitiveness of a country’s goods and services, which is influenced by supply-side policies, impacts how many exports the country has.
- A country can become more competitive by being innovative, having higher quality goods and services, operating in a niche market, having lower labour costs, being more productive or by having better infrastructure. These increase exports.
- Trade deals and being part of trading blocs can influence how much a country exports. This either opens up a country to, or closes a country from, significant export opportunities.
90
What is economic activity?
- Can mean many things
- Centring on the production and consumption of goods and services in the economy, together with the employment of the labour, capital and other inputs that produce output
91
Draw the AD/AS diagram that can be used to illustrate how changes in aggregate demand affect the level of real output?
(textbook)
92
What does the diagram show? (textbook pg.342 left diagram)
- Illustrates the effect of an increase in aggregate demand on real output
- Shows how a rightward shift of the AD curve leads to an increase in real output
- Shows the expansionary effect of an increase in aggregate demand
93
What are two points to note about the diagram to always remember (textbook pg.342 left diagram)?
- The greater the shift in aggregate demand, the greater the change in real output
- The extent to which real output changes also depends on the steepness of the AS curve
94
What're the factors that influence the level of economic activity?
- Employment - Influences production and consumption
- Confidence - Influences the level of spending and investment
- Events - Natural disasters or Christmas influence the level of consumer spending
- Other factors - E.g. taxes and interest rates influence how much firms and
consumers borrow, save or spend.
95
What is meant by multiplier?
The relationship between a change in aggregate demand and the resulting generally larger change in national income
96
When does the multiplier effect occur?
- Occurs when there is new demand in an economy
- This leads to an injection of more income into the circular flow of income, which leads to economic growth
- This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created
- It occurs since ‘one person’s spending is another person’s income’.
97
What does the multiplier effect refer to?
How an initial increase in AD leads to an even bigger increase in national income.
98
What is the multiplier ratio?
The number of times a rise in national income is larger than the rise in the initial injection of AD, which led to the rise in national income.
99
What occurs when an economy has a lot of spare capacity relating to the multipliers significance to shifts in AD?
- Extra output can be produced quickly and at little extra cost
- This makes SRAS elastic and it means the size of the multiplier will be larger
- A small increase in AD will lead to a large increase in national income.
100
Draw where the national income multiplier is illustrated on an AD/AS diagram?
textbook
101
What does the diagram show?
- An initial increase in government spending (?G) shifts the AD curve from AD1 to AD2
- This then triggers the multiplier process, which leads to a further increase in aggregate demand to AD3
- If the size of the government spending multiplier is 2.5, then, the eventual increase in aggregate demand is two and a half times the size of the initial increase in government spending
102
Why is it that if SRAS is inelastic, the multiplier effect is likely to be smaller than its potential?
- Because if AD increases, prices will increase rather than a full increase in national income
- This higher rate of inflation will lead to higher interest rates
- This will discourage spending and borrowing, and it will encourage saving, since the reward for saving is higher
103
What is a 'reverse' multiplier?
- When a withdrawal of income form the circular flow of income could lead to an even larger decrease in income for the economy
- This could decrease economic growth and potentially lead to a decline in the economy.
104
What equation is used to show multiplier relationship?
pg.343 textbook
105
What happens the higher the Marginal propensity to consume (MPC)?
The higher the MPC, the bigger the size of the multiplier
106
How could the government influence the Marginal propensity to consume (MPC)
- By changing the rate of direct tax
- If consumers have more disposable income due to lower income tax rates, their propensity to consume might increase.
107
What is the outcome (consumer’s marginal propensity to save (+) the marginal propensity to consume)
Equal to 1
108
What are the two formulas for calculating the value of the multiplier?
textbook pg 345
109
What does high marginal to consume mean?
- At each stage of the multiplier process, most new income is spent on consumption and only a small amount leaks into saving
- In this situation, multipliers are relatively large
110
What is the formula showing the relationship which = nominal national income?
- Nominal national income = real national income x average price level
- Y = Py
111
What is the overall summary of the multiplier?
It measures the relationship between a change in any of the components of aggregate demand and the resulting change in the equilibrium level of national income
112
When does the SRAS curve shift?
When there are change sin the conditions of supply
113
What are the main determinants of SRAS?
- The price level
- Production costs
114
What're the factors that cause a shift (rightward) of the SRAS curve?
- The cost of employment might change, e.g. wages, taxes, and labour productivity
- The cost of other inputs e.g. raw materials, commodity prices, and the exchange rate if products are imported. A stronger currency reduces the price of imports, so imported products will be cheaper
- Government regulation or intervention, such as environmental laws or green taxes and business regulation. Business regulation is sometimes called ‘red tape’.
- There could be a net outward migration of workers, which causes a ‘brain drain’ on the domestic economy, as skilled workers move elsewhere.
- If there is a fall in business capital spending, supply will fall.
115
What does this diagram suggest? (LRAS curve)
- That output is fixed at each level. All factors of production in the economy are fully employed in the long run
- This means that changing AD, such as from AD1 to AD2, only makes a change in the price level (P1 to P2), and it will not change national output (real GDP)
116
What does the position of the vertical LRAS curve represent?
The normal capacity level of output of the economy
117
What is meant by normal capacity level of output?
The level of output at which the full production potential of the economy is being used
118
What is the LRAS curve influenced by?
1. Quantity of factors of production
2. Quality of the factors of production
3. Productive efficiency (long run cost of production falling)
119
What are the factors that determine the position of the LRAS curve?
- Technological advances
- Changes in relative productivity
- Changes in education and skills
- Changes in government regulations
- Demographic changes and migration
- Competition policy
120
How are technological advances a factor that determines the position of the LRAS curve?
If more money is spent on improving technology, the economy can produce goods in larger volumes or improve the quality of goods and services produced.
121
How are changes in relative productivity a factor that determines the position of the LRAS curve?
A more productive labour and capital input will produce a larger quantity of output with the same quantity of input
122
How are changes in education and skills a factor that determines the position of the LRAS curve?
This improves the quality of human capital, so it is more productive and more able to produce a wider variety of goods and services
123
How are changes in government regulations a factor that determines the position of the LRAS curve?
Government regulation could limit how productive and efficient a firm can be if it is excessive. This is sometimes referred to as ‘red-tape’
124
How are demographic changes and migration a factor that determines the position of the LRAS curve?
If there is net inward migration and the majority of the population is of working age, the size of the labour force is going to be significant, which means the economy can increase its output.
125
How is competition policy a factor that determines the position of the LRAS curve?
A more competitive market encourages firms to be more efficient and more productive, so they are not competed out of business. Governments can use effective competition policy to stimulate this in the economy
126
Draw the Keynesian LRAS curve?
127
What does the Keynesian LRAS curve view suggest?
- That the price level in the economy is fixed until resources are fully employed
- The horizontal section shows the output and price level when resources are not fully employed; there is spare capacity in the economy.
- The vertical section is when resources are fully employed.
- Over the spare capacity section, output can be increased (AD1 to AD2) without affecting the price level (stays at P1).
- Once resources are fully employed, an increase in output (AD3 to AD4) will be inflationary (price level increases from P2 to P3).
128
b) what was the change in net export demand between 2019 and 2020?
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