2.4 Flashcards
What is the circular flow of income in a two-sector economy?
Households provide firms with land, labor, and capital in exchange for rent, wages, interest, and profits. Money flows from households to firms, while goods and services flow from firms to households.
This model simplifies economic interactions to illustrate basic concepts of income and expenditure.
How is national output measured in the circular flow of income?
National output is measured as the value of the flow of goods and services from firms to households.
It is one of three ways to measure economic activity, alongside national expenditure and national income.
What are the three ways of measuring economic activity?
- National output
- National expenditure
- National income
In the basic two-sector model, these three measures are equal.
What role does the government play in the circular flow of income?
The government takes money out through taxation (T) and adds money through spending (G).
Government spending can increase the flow of income if it exceeds taxation.
What are injections in the economy?
- Government spending (G)
- Investment (I)
- Exports (X)
Injections increase the total money in the economy.
What are withdrawals in the economy?
- Taxes (T)
- Savings (S)
- Imports (M)
Withdrawals remove money from the economy.
What happens when injections exceed withdrawals?
The economy will be growing.
Conversely, if withdrawals exceed injections, the economy will shrink.
What is the equilibrium position of national output?
It is where the aggregate demand (AD) curve and the aggregate supply (AS) curve intersect.
Shifts in either curve can change this equilibrium.
In the short run, how do Keynesian and Classical economists view aggregate supply and demand?
They agree that AD is downward sloping and AS is upward sloping.
This reflects the interactions between price levels and real GDP.
What happens to national output in the long run according to Classical economists?
The long run aggregate supply (LRAS) curve is perfectly inelastic, meaning changes in AD will not affect output, only price.
Classical economists believe the economy returns to full employment in the long run.
What is the impact of a rise in long run aggregate supply (LRAS)?
It is likely to lead to lower prices and higher output.
This contrasts with a rise in AD, which increases prices without increasing output.
How do Keynesian economists differ from Classical economists regarding LRAS?
Keynesians believe that equilibrium can occur at less than full employment, where the LRAS curve is horizontal.
They do not see a rapid fall in real wages leading to a decrease in unemployment.
What is the multiplier process?
It is the idea that an increase in aggregate demand (AD) from injections can lead to a larger increase in national income.
The multiplier is calculated as the ratio of the final change in income to the initial change in injection.
What factors determine the size of the multiplier?
The size of the multiplier is determined by the marginal propensity to consume (MPC) and the level of leakages.
A higher MPC leads to a larger multiplier.
What are the marginal propensities related to income changes?
- Marginal propensity to consume (MPC)
- Marginal propensity to save (MPS)
- Marginal propensity to tax (MPT)
- Marginal propensity to import (MPM)
- Marginal propensity to withdraw (MPW)
MPW is the sum of MPS, MPT, and MPM.
What is the relationship between MPC and the multiplier?
The higher the MPC, the bigger the multiplier.
This is because more income is spent, leading to greater transfers through the circular flow.
What is the formula for the multiplier?
Multiplier = 1 / (1 - MPC)
This formula illustrates how the MPC affects the overall multiplier effect.
What happens if the AS curve is perfectly inelastic?
The only impact of the multiplier will be to increase prices, not output in the long run.
This scenario typically occurs on the classical LRAS curve.
What is a negative multiplier effect?
A withdrawal from the economy could lead to a further fall in income, decreasing economic growth.
This can occur when government plans to cut deficits are implemented.
