2.1 The Level Of Overall Economic Activity

Question 1

What is the circular flow of income model?

Answer 1

Macroeconomic tool used to explain how economic activity and national income are determined.

Question 2

What are households and firms in the circular flow of income model?

Answer 2

Households are individuals with effective demand for goods and services.
Firms are businesses that supply goods and services.

Question 3

What are the three types of withdrawal?

Answer 3

Savings (S) to banks, taxation (T) to government, and import expenditure (M) to foreign sector.

Question 4

What are the three types of injection?

Answer 4

Government spending (G), investment expenditure (I) and export earnings (X).

Question 5

What is the condition for income equilibrium?

Answer 5

S + T + M = G + I + X

Question 6

What does the level of economic activity depend on?

Answer 6

Size of injections (J) and withdrawals (W).

If W > J economic activity declines.

Question 7

What is income?

Answer 7

Sum of returns for use of four factors of production:
return for land (rent)
return for labour (wages)
return for capital (interest)
return for enterprise (profit)

Question 8

What happens in a closed economy?

Answer 8

Households supply factors of production to firms - generate output of goods and services.
Firms provide factor incomes to households.
Households spend income on goods and services produced by firms creating expenditure revenue for firms.
Income flow is numerically same as expenditure flow and output flow.

Question 9

What happens in an open economy?

Answer 9

There is a government sector, financial markets and foreign trade.
In financial sector saving (S) represent a withdrawal, investments (I) are injections.
With a government sector taxes (T) represent a withdrawal, government spending (G) is an injection.
Foreign sector with international trade, export revenue (X) represents injection, whereas import expenditure (M) is a leakage.

Question 10

What is gross domestic product (GDP)?

Answer 10

Value of all final output of goods and services produced by firms within a country per year.

Question 11

What is gross national product (GNP)?

Answer 11

Value of all final output of goods and services produced by a country’s citizens both domestically and abroad.

Question 12

What are the three ways to measure economic activity?

Answer 12

The value of national output (O)
National income (Y)
National expenditure (E)

Question 13

What does the output method of measuring economic activity involve?

Answer 13

Adds up final value of newly produced goods and services during the year.

Question 14

What does the national income method of measuring economic activity involve?

Answer 14

Adds up total value of all factor incomes earned during the year.

Question 15

What does the expenditure method of measuring economic activity involve?

Answer 15

Adds up the total spending on newly produced goods and services during the year.

Question 16

Why do all three methods give the same numerical result?

Answer 16

Value of national output equals value of what is spent on the output (national expenditure). This expenditure becomes national income to households and firms that produced the output.

Question 17

What is the formula for calculating GDP?

Answer 17

GDP = C + I + G + (X-M)

C is consumption expenditure
I is investment expenditure 
G is government expenditure 
X is export earrings 
M the amount spent on imports

Question 18

What else does GNP account for?

Answer 18

Uses GDP but accounts for net property income from abroad ie. difference between what residents earn from overseas investments minus income earned by foreign residents within domestic economy.

Question 19

What is the formula for GNP?

Answer 19

GNP = GDP + net property income from abroad.

Question 20

What is net property income from abroad?

Answer 20

Refers to difference in value between incomes earned and incomes paid abroad. .

Question 21

How is nominal GDP measured?

Answer 21

By using current market prices - value of GDP at the time of measurement.

Question 22

How is real GDP measured?

Answer 22

Takes account of fluctuations in prices (inflation over time).

Question 23

What is the benefit of using real GDP?

Answer 23

Allows better comparisons of economic activity over time by using constant market prices, values are adjusted for inflation over time.

Question 24

What is GDP per capita?

Answer 24

Expressing GDP per head of the population ie. averages out total GDP per person in the country.

Question 25

How is GDP per capita measured?

Answer 25

GDP per capita = total GDP/population size

Question 26

How is GNP per capita measured?

Answer 26

GNP or GNI per capita is calculated in the same way - dividing the total GNP or GNI by country’s population size.

Question 27

What do national income statistics give an indication of?

Answer 27

Standards of living in a country, higher real GDP per capita is associated with higher standards of living for average person. A persons standard of living is directly dependant upon amount of goods and services they are able to consume.
Reveal average persons social and economic wellbeing.

Question 28

What are some limitations of using national income statistics to measure standards of living in a country?

Answer 28

Distribution of income and wealth in the country.
Varying rates of direct and indirect taxes between countries.
Differences in cost of living.
Extent of social welfare benefits varying between countries.
Exchange rate fluctuations making international comparisons of GDP over time less meaningful.
Composition of national output.
Extent to which national output generates negative externalities limiting sustainability of economic activity and quality of life in the country.
Variations in the rise of unofficial economy for goods and services that are not officially traded.
Consideration of alternative measures of GDP to measure standard of living eg HDI.

Question 29

What is green GDP?

Answer 29

Measure of GDP that accounts for environmental destruction of economic activity by deducting environmental costs associated with output of goods and services.

Question 30

How is green GDP calculated?

Answer 30

green GDP = nominal GDP - environmental productions costs.

Question 31

What is the business cycle?

Answer 31

Describes fluctuations in economic activity in a country over time which create a long term trend of growth in the economy.

Question 32

What does a peak show on the business cycle?

Answer 32

There is an economic boom where economic activity is at highest level. Unemployment is low, consumer and business confidence levels are very high.

Question 33

What does a slump show on the business cycle?

Answer 33

There is a recession where level of economic activity declines. Occurs when GDP falls for two consecutive quarters. Business failure is common and unemployment rises. Recession creates uncertainty for firms and damage consumer confidence levels. Slump occurs at the bottom of recession. There is mass unemployment as consumption, investment and net export earnings remain low.

Question 34

When does a recovery on the business cycle occur?

Answer 34

When the level of GDP rises after a slump. Consumption, investment and net exports gradually rise, thus creating employment opportunities and increasing business confidence.

Question 35

What is shown by the long term trend in the business cycle?

Answer 35

Potential national output (potential GDP) of an economy.

Question 36

What are exogenous shocks?

Answer 36

Outside factors that affect potential growth of an economy eg. global financial crises, outbreak of infectious diseases and natural disasters.

Question 37

What is economic growth?

Answer 37

The increase in level of economic activity.

Question 38

Why is economic growth good for an economy?

Answer 38

Increases long term productive capacity of economy, illustrated by an outwards shift of PPC. Suggests economy is more prosperous so average person earns more income.