2.4 National Income

Question 1

define the circular flow of income, expenditure and output

Answer 1

a model of the economy which shows the movement of goods and services between households and firms and their corresponding payments in moeny terms

Question 2

who owns all the wealth and resources in the circular flow?

Answer 2

the households

Question 3

what do the firms pay the households for?

Answer 3

the firms pay the households for the resources such as labour with wages

Question 4

what do the households pay the firms for?

Answer 4

they pay the firms for goods and services with their wages

Question 5

what are injections into the circular flow?

Answer 5

government spending, investment and exports

Question 6

what are withdrawals from the circular flow?

Answer 6

taxes, producers or consumers saving under (outside of the bank) , imports

Question 7

define wealth?

Answer 7

wealth is a stock concept, the accumulation of assets such as property or shares

Question 8

define income?

Answer 8

a flow concept, the amount of money that is earned in a given period

Question 9

how are wealth and income related?

Answer 9

wealth can create income for example dividends on stocks or rent on property

Question 10

what has higher inequality in the UK wealth or income?

Answer 10

there is a higher wealth inequality , the top 10% of income own 43.8% of wealth

Question 11

when is an economy growing?

Answer 11

If the sum of injections is greater than the sum of leakages/withdrawals, then the economy will be growing

Question 12

when is an economy shrinking?

Answer 12

if injections are smaller than withdrawals, it will be

shrinking.

Question 13

when is an economy in equilbirum?

Answer 13

In an equilibrium, injections must be equal to withdrawals and so the national income remains the same

Question 14

where is the equilibrium position of national output?

Answer 14

this position is where the AD curve and the AS curve intersects

Question 15

what does the AD curve look like in the short run and long run?

Answer 15

downward sloping

Question 16

what does the AS curve look like in the short run for Keynesian and classical economics?

Answer 16

it is upward sloping

Question 17

what does the AS curve look like in the long run for Keynesian economics and why?

Answer 17

the curve bends upwards starting horizontal then being vertical, they believe there can be equilibrium at less than full employment

Question 18

what does the AS curve look like for the classical economists and why?

Answer 18

it is a vertical line, the classical LRAS curve is perfectly inelastic. this is due to the fact they believe the economy will always end up at full employment in the long run.

Question 19

what do the classical economists believe will happen when the AD curve shifts to the right ?

Answer 19

They believe that the increase in AD will lead to a positive output gap. The economy is in long term disequilibrium as SRAS and AD do not intersect on the LRAS curve. This means that there is over-full employment and firms will end up bidding up wages of labour ) and the other factor prices. As a result, SRAS shifts left as the cost of production has increased. Eventually, the economy is producing the same amount but now at higher prices. The short run equilibrium has shifted and is now the same as the long run equilibrium

Question 20

what is the only way classical economists think is possible to increase output ?

Answer 20

the only way to increase output is by increasing the LRAS as Changes in AD without a change in
the LRAS are only inflationary

Question 21

what is likely to happen when an LRAS curve shifts right?

Answer 21

A rise in long run aggregate supply is likely to lead to lower prices and higher output.

Question 22

what type of policies do classical economists prefer?

Answer 22

classical economists favour supply-side policies over demand management as rises in long run aggregate supply is likely to lead to lower prices and higher output whereas a rise in AD which causes increase prices and no higher output

Question 23

for a Keynesian long run curve what does the impact of a shift in AD depend on ?

Answer 23

the impact of a shift in AD strongly depends on the

elasticity of the curve, and hence whether the economy is at or near full employment.

Question 24

what is the impact of a shift right of LRAS curve in Keynesian economists?

Answer 24

If the economy is producing at or near full employment, for example at AD1, then a rise in LRAS will increase output and decrease the price level. However, if the economy is in a deep recession (low levels of employment) then an increase in LRAS will have no effect on prices or output.

Question 25

what do Keynesian economists believe should happens during times of recession?

Answer 25

Keynesians argue that during recessions the government needs to work to increase AD rather than using supply side policies.

Question 26

what is the effect of investment on AD and AS?

Answer 26

investment is a component of AD so 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. This may mean that the long run disequilibrium caused by the shift in AD will be brought back to equilibrium by an increase in LRAS rather than a fall in AD. However, not all investment results in increased production and so the LRAS will not increase. Therefore, the extent to which investment increases output and lessens inflation depends on its rate of return.

Question 27

what is the multiplier effect?

Answer 27

The multiplier process is the idea that an increase in AD because of an increased injection (exports, government spending or investment) can lead to a further increase in national income. It is the ratio of the final change in income to the initial change in injection

Question 28

why does the multiplier effect work?

Answer 28

The multiplier is able to work due to the concept of circular flow, since one person’s spending is another’s income.

Question 29

what is the average multiplier for developed countries according to the IMF?

Answer 29

The IMF have calculated that in developed countries,

the multiplier tends to be around 1.5 in the long run and about 1.6 for developing countries.

Question 30

what is a negative multiplier effect?

Answer 30

A negative multiplier effect can also occur i.e. a withdrawal from the economy could lead to an even further fall in income, decreasing economic growth and
possibly leading to a decline in the economy.

Question 31

what is the effect of the multiplier effect on the economy?

Answer 31

The multiplier means that growth can occur quicker , as any injections lead to a bigger increase in national income. Injections can be targeted at those with the
biggest MPC in order to increase the size of the multiplier.

Question 32

what are evaluation points for the multiplier effect?

Answer 32

it is impossible for the government to know the exact effect of their spending as it is difficult to know the size of the multiplier. there will be a time lag between the increase in income and the full effect of that increase as not everyone will spend the money straight away. The overall effect on the economy will depend on the change in AD and the elasticity of the AS curve.

Question 33

what is the marginal propensity to consume?

Answer 33

Marginal propensity to consume (MPC): The proportion of the extra income that is spent on consumption

Question 34

what is the marginal propensity to save?

Answer 34

Marginal propensity to save (MPS): The proportion of the extra income that is saved

Question 35

what is the marginal propensity to tax?

Answer 35

Marginal propensity to tax (MPT): The proportion of the extra income that is lost on taxes

Question 36

what is the marginal propensity to import?

Answer 36

Marginal propensity to import (MPM): The proportion of the extra income that is spent on imports

Question 37

what is the marginal propensity to withdraw?

Answer 37

Marginal propensity to withdraw (MPW): The proportion of the extra income that is leakages MPW=MPS+MPT+MPM

Question 38

what is the equation for the multiplier?

Answer 38

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

Question 39

what effects the size of the multiplier?

Answer 39

The multiplier is dependent on MPC and so can change all the time. MPC depends on a range of factors; any factor that affects consumption (as a component of AD) will affect the MPC, for example a change in interest rates will affect the MPC.

Question 40

what are the effects of a change in AD?

Answer 40

The multiplier leads to an increase in AD higher than the original increase but for it to have the desired effect, there must be sufficient spare capacity in the economy (i.e. it cannot be at full output) for extra output to be produced. If the AS is perfectly inelastic, like on the classical LRAS curve, then the only impact of the multiplier will be to increase price. The more elastic the curve, the smaller the effect on price but the bigger the effect on output.

Question 41

what does the final change in AD depend on?

Answer 41

the initial change in the AD and also the size of the multiplier.

Question 42

when does the biggest change in AD occur?

Answer 42

the multiplier will have a big effect when there is plenty of spare capacity in the economy and the MPW is low/MPC is higher.

Question 43

when does the smallest change in AD occur?

Answer 43

It has little effect on output when there is little spare capacity in the economy so the rising demand only creates rising prices.