2.2 How the macroeconomy works: the circular flow of income, AD/AS analysis, and related concepts Flashcards
Household
people living under one roof. They demand goods and services, and supply land, labour, capital, and enterprise.
Firm
a productive organisation which sells its output of goods or services commercially
National income (Y)
all the incomes generated from producing goods and services in a country in a year. This included wages (from labour), rent (from land), interest (from capital), and profit (from enterprise)
National Output (O)
the value of all the goods and services produced in a country in a year
National expenditure (E)
the money spent on all the goods and services in a country in a year
Withdrawal (W)
a leakage of spending power out of the circular flow of income into savings, taxation, and imports
What are the 3 components of total withdrawals?
- savings
- taxation
- imports
Injection (J)
spending entering the circular flow of income as a result of investment, government spending, and exports
What are the 3 components of total injections?
- investment
- government spending
- exports
Savings (S)
income which is not spent
Investment (I)
total planned spending by firms on capital goods produced within the economy
Taxation (T)
money collected by the government
Government spending (G)
money spent by the government
Imports (M)
goods or services produced in other countries and sold to residents of this country
Exports (X)
goods or services produced in this country and sold to residents of other countries
What happens when W=J?
national income in equilibrium
What happens when W>J?
national income is falling
What happens when W<J?
national income is rising
Disposable income
income over a period of time including earnings and benefits, less direct taxes
Consumption (C)
total planner spending by households on consumer goods and services produced within the economy
Marginal propensity to consume (MPC)
the fraction of an increase in disposable income that people plan to spend on domestically produced consumer goods
What is the formula for the marginal propensity to consume?
MPC = change in consumption/change in income
Average propensity to consume (APC)
the fraction of disposable income spent on domestically produced consumer goods
What is the formula for average propensity to consume?
APC = consumption/income
Multiplier (k)
the relationship between an initial change in aggregate demand and the resulting (usually larger) change in national income
What is the formula for the multiplier effect?
k=1/(1-MPC)
How do you calculate the change in national income from the injection and the multiplier?
ΔY=Jk
Equilibrium national income
the level of income at which withdrawals from the circular flow of income equal injections into the flow. Alternatively, the level of real output at which aggregate demand equals aggregate supply.
Aggregate
a whole formed by combining several different elements
Real
a prefix used in economics to indicate that the value has been adjusted for inflation
Price level
the average of all prices of goods in the economy
Real National output
the value of all goods and services produced in a country in a year adjusted for inflation
Aggregate demand (AD)
the total planned spending on real output produced within an economy
Aggregate supply (AS)
the aggregate level of real output that all firms in the economy plan to produce at different price levels
What is the formula for AD?
AD = C + I + G + (X - M)
What are the determinants of consumption? (8)
- interest rates
- level of income
- expected future income
- wealth
- consumer confidence
- availability of credit
- distribution of income
- expectations of future inflation
How do house prices affect consumption?
- increase in house prices often causes homeowners to consume more
- borrowing increases as house buyers take out mortgages, which finances extra consumption
- induces a ‘feel-good factor’ among property owners, leading to a consumer spending spreee
Savings ratio
a measure of actual savings as a ratio of disposable income
How do you calculate the savings ratio?
actual saving/disposable income
Interest rate
the reward for lending savings to somebody else and the cost of borrowing
What are the determinants of investment? (5)
- interest rates
- future maintenance costs of the investment
- relative prices of capital and labour
- nature of technical progress
- adequacy of financial institutions in the supply of investment funds
Accelerator effect
a change in the level of investment in new capital goods is induced by a change in the rate of growth of national income or aggregate demand
Short-run aggregate supply (SRAS)
aggregate supply when the level of capital is fixed, though the utilisation of existing factors of production can be altered so as to change the level of real output
Incentive function
a higher price creates an incentive for firms to supply more of a good or a service
Law of diminishing returns
where increasing amounts of a variable factor and added to a fixed factor and the amount added to total product by each unit of the variable factor eventually decreases
Short-run production
occurs when a firm adds variable factors of production to fixed factors of production
Long-run aggregate supply (LRAS)
aggregate supply when the economy is producing at its production potential (the maximum sustainable level of output that the economy can currently produce)
Macroeconomic long run
a sufficient period of time for nominal wages and other input prices to change in response to a change in the price level; the long run is not any fixed period of time. Instead, this refers to the time it takes for al prices to fully adjust
Long run economic growth
an increase in the economy’s potential level of real output, and an outward shift of the economy’s production possibility frontier
What are the determinants of short-run aggregate supply? (5)
- costs of production
- unit labour costs due to a change in wage rates or labour productivity
- taxation
- subsidies
- technical progress of capital goods
What are the determinants of long run aggregate supply? (7)
- state of technical progress
- quantities of factors of production in the economy
- mobility of factors of production
- productivity of factors of production
- personal enterprise
- the existence of appropriate economic objective
- the institutional structure of the economy (e.g. efficient contract law and banking system promote long-run economic growth and rightwards shift in LRAS)
Quantity theory of money
a theory that states inflation is caused by increases in the money supply
Monetarists
economists who argue that inflation is caused by prior increases in the money supply
Money supply
the stock of money in the economy at a particular point in time
Velocity of circulation of money
how fast money passes from one holder to the next
Fisher equation of exchange
the stock of money in the economy multiplied by the velocity of circulation equals the price level multiplied by the quantity of real output in the economy
Fisher equation of exchange formula
money supply (m) x velocity of circulation of money (v) = price level (p) x quantity of real output (q)
Describe what happens when the government increases money supply (5)
1) the government decides to increase the money supply
2) as that money begins to be spent, real incomes rise
3) causing a fall in the number of times each bank note is exchanged
4) but this causes demand-pull inflation
5) causing real incomes to fall back to initial levels
Assumptions under the quantity theory of money (3)
- money is not saved (it is all spent)
- the economy is at full employment
- velocity of transactions is independent of other variables
Why does an increase in the money supply cause inflation?
“too much money chasing too few goods”
