10 How the macroeconomy works : the circular flow of income, AD/AS analysis, and related concepts (MACRO) Flashcards
what is aggregate demand
AD = total spending on goods/services
AD = C + I + G + (X-M)
where:
C - consumption (consumer expenditure)
I - investment (spending on capital)
G - government spending (spending on state provided goods)
X-M - exports - imports (exports are injection and imports are leakage from circular flow)
what are shocks to aggregate demand
Unexpected changes to levels and some are:
- large rise/fall in exchange rate (affects export demand)
- recession (affecting export demand)
- slump in housing market or change in share prices
- credit crunch (credit available for borrowing, global financial crisis)
- unexpected cut/rise in interest rates or taxation
ALL CAUSE AD CURVE SHIFT
what is AD curve and what does it depict and caused by
AD curve showing INVERSE relationship between PL and GDP
caused by:
1. FALLING REAL INCOMES - PL rises so falling incomes
2. BALANCE OF TRADE - rise in PL of country X = foreign produced goods cheaper, fall in X rise in M and AD contraction
3. INTEREST RATE EFFECT - PL rise = inflation, increase demand for money, deflationary effect
factors affecting shifts in AD?
- EXPECTATIONS CHANGE (confidence falls, savings increase)
- CHANGES IN MONETARY POLICY (lower interest = lower cost of borrowing = more consumption/investment)
- FISCAL POLICY CHANGES (income tax affecting disposable income, government may increase expenditure)
- ECONOMIC EVENTS (overseas incomes increase = export demand increases, currency depreciates = exports cheaper and imports not)
- CHANGES IN HOUSEHOLD WEALTH (declining asset prices = fall in expectations)
- CHANGES IN SUPPLY OF CREDIT (credit availability)
what does consumption involve
CONSUMPTION - spending by households on goods/services
biggest component of AD, income sourced from wages, savings, investments, pensions, benefits
what can data is involved with consumption
SAVINGS RATIO - ratio of personal saving to disposable income
FTSE-100 INDEX - share prices of 100 largest companies on London stock exchange
VAT - tax on consumption
what is involved with marginal propensity to consume
this is rate at which consumers increase spending as income increases
people with lower income have higher propensity
fall in this = lower consumption for given income level
what factors determine consumer spending
- REAL INCOMES (wages rising faster than prices = higher incomes = higher purchasing power)
- DIRECT AND INDIRECT TAXATION (cut = higher income, rise = lower income)
- INTEREST RATES (lower = cut cost of debt = higher disposable income)
- HOUSEHOLD WEALTH (negative wealth effect)
- CONSUMER CONFIDENCE (low = less spending)
- SUPPLY OF CREDIT (banks less willing to loan = interest higher)
- DISTRIBUTION OF INCOME (marginal propensity to consume)
- DEMOGRAPHICS (size/growth rate/age structure direct effect)
what is consumer confidence and how is it influenced
when low, people save more as low job security, financial crisis lower confidence
influenced by:
- economic growth
- household debt
- unemployment
- house prices
how do mortgage and interest rates affect consumer spending
mortgage rates fall = disposable income rise so purchasing power increases however with fixed mortgages interest rates don’t take effect immediately
what is the wealth effect and how does it affect spending
wealth represents value of a stock of assets and is held in properties, shares, savings, money etc
many economists think there is a positive relationship between wealth and spending
real value of savings and income affect purchasing power
how would share prices affect consumer spending
rise in FTSE-100 might increase consumer spending if confidence increased
consumer spending power boosted from rise in share dividend payments
what is involved with consumer borrowing
- UNSECURED BORROWING - loan/overdraft not tied to another asset eg bank loans
- SECURED BORROWING - lending where borrower must use another asset as collateral for loan in case of failure to pay
what is involved with saving in the economy
SAVING - household disposable income not spent
disposable income = income after taxes and benefits
high savings ratio lowers consumption and AD
factors affecting how much income people save
- REAL INTEREST RATE (nominal rate adjusted for inflation)
- PRICE EXPECTATIONS (deflation may = more saving)
- AVAILABILITY OF CREDIT
- UNEMPLOYMENT / JOB SECURITY (rising unemployment = saving more)
- CONSUMER CONFIDENCE/ EXPECTATIONS/ UNCERTAINTY (stronger = people more willing to borrow)
- TAXATION OF SAVINGS (interest on savings taxed)
- TRUST IN SAVINGS INSTITUTION (deposit guarantees encourage higher saving)
- NEED TO PAY BACK DEBT
what is the importance of saving for an economy
- corporate savings provide cushion during recession when demand and profits fall, savings used for finance
- savings are household wealth and provide buffer against uncertain times
whats the paradox of thrift
whats beneficial to individual = damaging to economy
KEYNESIAN - saving is positive as provides funds to finance capital investment, long term growth promoted
what is involved with spending
- spending on capital goods and spending on human capital
- spending on infrastructure
- done by most private businesses but can come from government
difference between gross and net investment
GROSS = total amount economy spends on new capital including capital depreciation
higher productive capacity for businesses meeting rising demand in future if gross higher than depreciation
GROSS - CAPITAL DEPRECIATION = NET INVESTMENT
what are advantages of investment
- injection into circular flow of income
- can boost productivity creating additional capacity to supply
- extra demand in investment goods, multiplier effect on GDP levels
- investment boosting country’s competitiveness so trade balance improved
how does investment influence AD
rise in capital spending = positive multiplier, boosts demand
some projects destroy jobs yet some create jobs yet high investment may not create increase in LRAS as worker training needed
if insufficient demand growing capital stock = excess capacity = downward pressure on prices/profits
whats the accelerator effect
relationship between planned capital investment and rate of change of national income
change in consumer good demand usually leads to bigger change in capital good demand
rate of growth of demand falls = investment falls
what is aggregate supply and what is SRAS/LRAS
AS measure volume of goods/services produced depicting ability to meet AD
SRAS shows total planned output when prices subject to change but productivity remains same, assumed to be upward sloping
LRAS shows total planned output when prices and average wage rates can change - potential PPF, assumed to be vertical
what causes movements in AS curve
change in PL = movement along SRAS
if AD rises, expansion of SRAS
if AD falls, contraction of SRAS
what causes shifts in SRAS curve
- CHANGE IN UNIT LABOUR COSTS (wage costs adjusted for productivity)
- CHANGES IN PRODUCTION COSTS
- COMMODITY PRICES (raw materials)
- EXCHANGE RATES (causes fluctuations in prices of imported products, fall = increased costs)
- GOVERNMENT TAXATION/SUBSIDIES (increase in taxes = inward shift)
- PRICE OF IMPORTS (cheaper = outward shift)
- SHORT RUN STOCKS TO PRODUCTION (temporary non-economic factors)
external factors influencing AS
- world gas/oil prices
- energy prices/costs
- food prices
- import tariffs/quotas
- other mineral/metal costs
what is the long run aggregate supply and what does it involve
ability of an economy to produce goods/services to meet demand
what are the factors affecting LRAS
- PRODUCTIVITY (efficiency of production process, determinant of economic growth, inflation and fall = rise in production costs, rise = higher wages and profts)
- INCREASED LABOUR MARKET PARTICIPATION
- GAINS FROM INNOVATION AND ENTERPRISE
- CAPITAL INVESTMENT
why is the UK lacking on productivity
- low capital investment
- banking crisis affects lending
- slowing rates of innovation
- persistent skills shortage
- low market competition
- low AD and high spare capacity
what will increased productivity result in
- lower inflation
- higher economic growth
- lower unemployment as higher growth
- improved balance of trades
- rise from extra capacity in short run
- higher investment, increased profits
what is involved within the Keynesian non linear aggregate supply curve
SRAS elastic when spare capacity high but this falls as output increases
rise in AD met easily by increased output. when SRAS perfectly inelastic economy is at full capacity
explain macroeconomic equilibrium
established when AD intersects with SRAS and is where level of income flowing round system is constant
if PL too high, excess supply = unsold stocks
if PL below, excess demand = rundown of stocks so need to expand output
what is the effects of an increase and decrease of AD
INCREASE = expansion of AS, higher equilibrium output and outward shift means cyclical rise in output and employment
DECREASE = lower equilibrium level of national output
what is the effects of an increase and decrease in AS
INCREASE = expansion of AD, higher equilibrium and outward shift of AS
DECREASE = contraction of AS and inward shift of AS as rise in unit resource costs so lower profits. AS can fall in short and long run
