1.1 Circular flow of income Flashcards
Explain and draw the circular flow of income.
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.
Explain leakages and injections into circular flow income.
Leakages:
-Savings
-Taxes
Imports
Injections:
-Government spending e.g, on merit goods/ welfare payments
-Exports
When does an economy reach a state of equlibrium?
Rate of withdrawals = the rate of injections.
Explain:methods of measuring national income, output and expenditure
> National income = National Output = National expenditure.
Calculated through:
1.Value added
2.Sum of incomes
3.Expenditure
Explain: Aggregate demand and its components
-Aggregate demand is the total demand in the economy.
-Equation: C + I + G +(X-M)
- Consumer spending
-Investment
-Government spending
-Net imports; Exports- Imports
Explain, with the aid of a diagram: The relationship between aggregate demand and price leveL (MOVING ALONG)
> Higher prices lead to a fall in the value of real incomes, so goods and services become less affordable in real terms.
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.
Explain, with the aid of a diagram:Shifts in the aggregate demand curve
The AD curve is shifted by changes in the components of AD (C, I, G or X-M):
Explain: Aggregate supply
> Aggregate supply shows the quantity of real GDP which is supplied at different price levels in the economy.
Explain, with the aid of a diagram:The relationship between aggregate supply and price level in the short run (MOVING ALONG)
Only changes in the price level, which occur due to changes in AD, lead to movements along the AS curve.
o 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.
Explain, with the aid of a diagram:Shifts in the aggregate supply curve in the short run and long run
- SRAS
- KEYNASIAN
- NEOCLASSICAL
> SRAS curve shifts when there are changes in the conditions of supply. The price level and production costs are the main determinants of SRAS.
> Keynesian long run AS:suggests that price level in economy is fixed until resources are fully employed. Horizontal section shows output and price level when resources are not fully employed; there is spare capacity in the economy. 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). In other words, output changes are not inflationary.
Once resources are fully employed, an increase in output (AD3 to AD4) will be inflationary (price level increases from P2 to P3).
> Neoclassical Aggregate Supply:In LR output is fixed at each level and all factors of production in economy are fully employed.
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).
The position of vertical LRAS curve represents normal capacity level of output of economy.
What are the factors influencing the long-run AS:
> Technological advances: Improved tech- expansion
> Changes in relative productivity: Improved productivity- expansion
> Changes in education and skills: Improved- expansion
> Changes in government regulations: e.g. red tape contraction.
> Demographic changes and migration: net inward migration and of working age- expansion
> Competition policy: Expansion
Explain:The assumptions underlying the aggregate demand and aggregate supply models
> For the AD curve, it is assumed that the supply of money available for borrowing is fixed.
> Both curves assume ceteris paribus, the assumption that all other factors remain constant.
> Vertical shape of LRAS curve assumes that economy is operating at full employment, and that price level and production costs change proportionally, so the economy maintains the level of full employment.
-Economy reaches state of equilibrium when AD=AS.
Explain: Factors which determine the size of the national income multiplier
> Marginal propensity to consume (MPC): measures proportion of extra income that is spent on consumption.
-Formula:change in consumption over the change in income.
-Higher the MPC, the bigger the size of the multiplier.
> Average propensity to consume is the percentage of income spent rather than saved.
-It is calculated by total consumption divided by total income.
> Marginal propensity to save : portion of additional disposable income that is saved by a consumer.
-Calculated by change in savings/change in income
> Average propensity to save is the income that is not spent.
-This is also known as the savings ratio.
-This is calculated by dividing the change in savings by the change in income.
> A consumer’s marginal propensity to save plus the marginal propensity to consume is equal to 1-If consumers save more than they spend, size of the multiplier will be small.
> Marginal propensity to tax (MPT): proportion of each pound taxed by the government.
-Higher rate of tax, less disposable income each consumer has, and smaller the size of multiplier.
> Marginal propensity to import (MPM)
If consumers spend income on imports rather than domestic g/s income is withdrawn from the circular flow of income. This reduces the size of the multiplier.
> Spare capacity in the economy:
If there is a negative output gap/ spare capacity impact of multiplier on national income will be greater than if economy is operating on an inelastic short run aggregate supply curve.
Explain, with the aid of a diagram:The national income multiplier and accelerator
> The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income.
> Accelerator effect states that investment levels are related the rate of change of GDP. Thus an increase in the rate of economic growth will cause a correspondingly larger increase in the level of investment
Explain Calculating size of national income multiplier and MPW
1/(1-MPC).
Example:If consumers spend 0.6 of every £1 they earn, they save 0/4. Therefore, the multiplier will be:
1/(1-0.6) = 1/0.4 = 2.5.
- The marginal propensity to withdraw is calculated by MPW = MPS + MPT + MPM
-Another formula for calculating the multiplier: 1/MPW
