1.1 Circular Flow of Income

Question 1

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What is the circular flow of income?

Answer 1

The Circular Flow of Income is a model of the economy which shows income flows from households to firms and back in a loop

Question 2

What is the equivalence of Income, Output and Expenditure for the CFOI model?

Answer 2

• the value of total income earned by households in the form of rent, interest, wages and profit is the national income (number 4 on diagram)
• value of total flow of goods and services from firms to households is the national output of the economy (number 2 on diagram)
• the value of total spending on goods and services tell us the national expenditure of the economy (number 3 on diagram)
• in the circular flow of income in its simple model says INCOME = OUTPUT = EXPENDITURE

Question 3

What are Injections in the CFOI model?

Answer 3

• injections are spending in the circular flow of income not from households, one of 3 things:
  1. Exports (X) - purchase of goods and services in the domestic market by foreign economic agents (households, firms, consumers)
  2. Government Spending (G) - total spending on goods and services by local and central governments
  3. Investment (I) - total spending on capital goods by firms

Question 4

What are Leakages in the CFOI model?

Answer 4

• leakages are spending by households that does not flow back to firms
  1. Imports (M) - purchase of foreign goods and services by domestic buyers
  2. Taxation (T) - total flow of income to governments, total tax revenue from firms and households
  3. Savings (S) - the part of income not spent by households

Question 5

What is macroeconomic equilibrium in the CFOI model?

Answer 5

• macroeconomic equilibrium is when injections = leakages with no tendency for income/output/expenditure to rise or fall
• injections = withdrawals/leakages, I + G + X = S + M + T
• if injections > withdrawals there will be a rise in national income
• if injections < withdrawals there will be a fall in national income

Question 6

What are the units of measuring national income?

Answer 6

• the key measure of national income in the UK is GDP, which is measured using market prices (including value of indirect taxes, which are not part of output however)
• GVA (gross value added) = GDP - ( indirect taxes + subsidies )
• GNI (gross national income) = GDP + net factor incomes from abroad (rent, interest, dividends)
• GNI - depreciation = Net National Income

Question 7

What is the formula for GDP deflator?

Answer 7

GDP Deflator = Nominal GDP / Real GDP x 100

Question 8

What is the income measure for measuring GDP

Answer 8

1. Income Measure
   
   • • income from self employment
   • • rental income
   • • gross trading profits from private and public companies/corporations
   • • other incomes

Question 9

What is the expenditure measure for GDP

Answer 9

1. Expenditure Measure (C + I + G + X - M)
   
   • • Consumer Spending
   • • investment expenditure
   • • Government Spendings
   • • Exports
   • • Imports

Question 10

What is the output measure for GDP?

Answer 10

1. Output Measure
   
   • • Primary sector output
   • • secondary sector output
   • • tertiary sector output
   • • stock appreciation (increase in value of existing stocks)

Question 11

What are 4 things that can challenge the accuracy of National Income statistics?

Answer 11

1. There are statistical inaccuracies in the data collected (which is why revised figures are published)
2. There is the hidden economy - some self-employed people may under-declare income to avoid taxes, criminal organisations also will mostly involve cash which cannot be traced, some countries may also have a large informal sector
3. Home-Produced goods and services are not accounted for
4. The value of the public sector is generally hard to measure and not accurate as public services are not bought or sold (generally measured through the cost of running it)

Question 12

What are 5 issues with comparing national income over time?

Answer 12

1. You must take into account the effect of inflation and the effect of population growth (look at real GDP and per capita)
2. Quality of goods and services may increase over time
3. Defence spending in periods of war will show higher defence expenditure and higher GDP, but this may not be reflected in standard of living
4. GDP figures do not take into account pollution and depletion of resources (externalities)
5. GDP figures do not show income distribution changes/ inequality

Question 13

What are 4 issues with comparing national income across countries

Answer 13

1. The quality of data and type of accounting varies across countries
2. The quality of goods and services varies greatly across countries
3. The geography (size, terrain) will influence goods and services consumed
4. All values must be converted to a common currency (depends on exchange rates) and exchange rates do not reflect purchasging power

Question 14

What is Purchasing Power Parity (PPP)

Answer 14

PPP takes into account the cost of living in different countries by measuring how much the same goods and services cost in different countries