2.4 National Income

Question 1

Circular Flow of Income Model

Answer 1

Question 2

Circular Flow of Income Simple

Answer 2

Households own all wealth and resources so provide firms with CLL in return for rent, wages, interest and profits
Money is used to buy goods and services from firms
Money flows in one direction, goods and services and factors of production in another

Question 3

Circular Flow of Income Measures

Answer 3

National Output: value of flow of goods and services from firms to households
National Expenditure: value of spending by households on goods and services
National Income: income paid by firms to households in return for CELL

O = E = Y

Question 4

Circular Flow of Income
Governments, Financial Services and Foreign Markets

Answer 4

Governments take money out of economy through taxation (T) and add by spending (G)
If government spends more than takes away => increases flow of income
Financial Services inject money through investments (I) and take away when consumers or producers save (S)
Foreign Markets add to flow through purchasing exports (X) and take away from selling imports (M) Balance of Trade

Question 5

Wealth and Income

Answer 5

Wealth is a stock of assets and things people own
Income is flow of assets and money received

Countries with high levels of wealth tend to have high levels of income and vice versa
No perfect correlation between wealth and income

Question 6

Injections

Answer 6

Monetary additions to the economy

• Government Spending (G)
• Investments (I)
• Exports (X)

Question 7

Withdrawals

Answer 7

Money being removed from the economy

• Taxes (T)
• Savings (S)
• Imports (M)

Question 8

Injections and Withdrawals

Answer 8

If sum of injections is greater than same of leakages/withdrawals then economy will be growing and vice versa
In an equilibrium, injections must be equal to withdrawals so NI remains the same

Question 9

Equilibrium Levels of Real National Output

Answer 9

Equilibrium Position of NO is where the AD and AS curves intersect
If either AS or AD is shifted then equilibrium position changes
Size of change depends on size of shift and elasticity of the curve which has not moved

Question 10

Short Run Equilibrium

Answer 10

Classical and Keynesian agree AD is downward sloping and AS is upward sloping

Question 11

SRAS Equilibrium

Answer 11

Initial equilibrium is P1Y1 where AD1 and SRAS1 intersect
Increase from SRAS1 to SRAS2 changes equilibrium position to P2Y2
Fall in price level and increase in real GDP
Decrease in SRAS leads to higher price levels and decreased real GDP

Question 12

SRAD Equilibrium

Answer 12

Initial equilibrium level is P1Y1 where AD1 = SRAS1
Increase in AD1 to AD2 leads to change in equilibrium position to P2Y2
Prices and real GDP are higher
Fall in AD leads to lower prices and real GDP

Question 13

Classical LRAS Equilibrium

Answer 13

LRAS curve is perfectly inelastic, a shift of AD curve would not affect LR NO and only price levels
Economy returns to full employment => no unemployment in the LR

Question 14

Classical LRAS Equilibrium Model
SRAS Shift

Answer 14

Increase from AD1 to AD2 leads to positive output gap
Economy is in LR disequilibrium as SRAS1 and AD2 do no intersect on LRAS1 curve
SR equilibrium is P2Y2
SRAS1 shifts to SRAS2 => cost of production increases
Economy is producing same amount but at higher prices Y1P3
SR equilibrium shifts and is now same as LR equilibrium

Question 15

Classical LRAS Equilibrium Model
LRAS Shift

Answer 15

Initial equilibrium is P1Y1 where AD1 = LRAS1
Increase in LRAS from LRAS1 to LRAS2 caused lower prices and higher output at P2Y2
SR disequilibrium as SRAS1 does not intersect curve, this will be closed by shift in SRAS

Question 16

Keynesian LRAS Equilibrium

Answer 16

Full employment when LRAS is vertical
Equilibrium less than full employment when curve is horizontal => rise in unemployment does not lead to fall in real wages
Impact of a shift in AD depends on elasticity of curve
Argue that government needs to work to increase AD rather than supply side policies during recessions

Question 17

Keynesian LRAS Equilibrium AD Shift

Answer 17

Shift from AD3 to AD4 is purely inflationary and only increases price, not output => equilibrium point changes from P2Y3 to P3Y3
If economy is in recession, increase from AD1 to AD2 only increases output, not price => equilibrium point changes from P1Y1 to P1Y2
Shift of any AD curve to or from AD5 => change in both price and equilibrium

Question 18

Keynesian LRAS Equilibrium LRAS Shift

Answer 18

If economy is producing at or near full employment (AD1), rise in LRAS increases output and decreases price level => change in equilibrium point from P1Y1 to P2Y2
If economy is in a recession (AD2), increase in LRAS has no effect on prices or output => P3Y3

Question 19

Increasing AD and AS

Answer 19

A factor which affects AD can easily affect AS
E.g. Investments
An increase in investment will increase AD but it could also increase LRAS as firms are able to produce more if they have more machines
=> LR disequilibrium caused by shift in AD will be brought back to equilibrium by increase in LRAS rather than fall in AD

Question 20

Multiplier Process

Answer 20

Idea that an increase in AD because of an increased injection (X, G, I) can lead to further increase in NI
Ratio of final change in income to the initial change in injection
Size of multiplier is determined by how much of an increase in income people will spend (MPC)
Lower leakage = higher MPC = higher multiplier

Question 21

Negative Multiplier Effect

Answer 21

Increased withdrawal from an economy could lead to an even further fall in income, decreasing economic growth
=> Decline in the economy
Government plans to cut deficits will lead to an even further decrease of the economy

Question 22

Multiplier Effects on the Economy

Answer 22

Growth can occur quicker as injections lead to bigger increase in NI
Injections can be targeted at those with the biggest MPC in order to increase size of the multiplier
There can also be a time lag between increase in income and full effect as not everyone will spend their money right away
Overall effect depends on change in AD and elasticity of AS curve

Question 23

Marginal Propensities

Answer 23

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)

Question 24

Effects of Marginal Propensities
Marginal Propensity to Consume

Answer 24

Increase in consumption following an increase in income

Question 25

Effects of Marginal Propensities
Marginal Propensity to Save

Answer 25

Increase in savings following an increase in income

Question 26

Effects of Marginal Propensities
Marginal Propensity to Tax

Answer 26

Increase in taxation following an increase in income

Question 27

Effects of Marginal Propensities
Marginal Propensity to Import

Answer 27

Increase in imports following an increase in income

Question 28

Effects of Marginal Propensities
Marginal Propensity to Withdraw

Answer 28

Increase in leakages following an increase in income

MPW = MPS + MPT + MPM

Question 29

Effects of Marginal Propensities

Answer 29

Multiplier is dependant on MPC so can change all the time
MPC depends on a rage of factors
Higher the MPC, bigger the multiplier as more money of income is spent so more money is transferred through the circular flow and less is withdrawn
Other MPs show how a change of income is withdrawn from economy => increase in any of these decrease MPC

Multiplier = 1/(1-MPC) = 1/MPW

Question 30

Multiplier effects on AD

Answer 30

Multiplier leads to an increase in AD higher than original increase but to have desired effect, there must be spare capacity in economy for extra output
If AS is perfectly inelastic, only impact of multiplier will be to increase price and it will not affect output in LR although it will in SR => more elastic curve, smaller effect on price but bigger on output