2.4 National Income

Question 1

Draw the Basic Circular Flow of Income

Answer 1

Question 2

What is an injection into the Circular Flow of Income

Answer 2

extra spending put into the circular flow model

Question 3

What are the 3 types of injections into the Circular Flow of Income Model

Answer 3

• Investment
• Exports of goods and services
• Government spending

Question 4

What is a leakage of income into the Circular Flow of Model

Answer 4

• Saving
• Imports of goods and services
• Taxation

Question 5

What is National Income

Answer 5

National income measures the monetary value of the flow of output of goods and services produced in an economy over a period of time (usually one year)

Question 6

What are the key uses of measuring National Income

Answer 6

• The rate of economic growth (real GDP)
• Changes to living standards (real GDP per capita)
• Changes to the distribution of income between groups within the population

Question 7

What is GDP

Answer 7

measures the total value of national output produced in a given time period (i.e. one year)

Question 8

What are the 3 ways that GDP calculated

Answer 8

1. Expenditure
2. Factor Incomes
3. Value of Output

Question 9

How do you calculate GDP with expenditure

Answer 9

C + G + I + Change in Value of Stocks + (X-M) = GDP (AD)

Question 10

How do you calculate GDP with factor incomes

Answer 10

• Income for people in jobs/self-employment
• Profits of public/private sector
• Rental income for land ownership

Question 11

How do you calculate GDP with value of outputs

Answer 11

• Value added from each of the main economic sectors:

1. Primary
2. Construction
3. Manufacturing
4. Tertiary
5. Quaternary

Value added = Value of Production - Value of intermediate inputs

Question 12

What are some low value added industries

Answer 12

• Textiles
• Mass processed foods
• Farming

Question 13

What are high value added industries

Answer 13

• Information technology
• Precision engineering
• Aerospace

Question 14

Let the nominal (or money) value of UK GDP in 2015 be £1,400 bn

The price index for 2015 is 100

In 2016, the nominal value of GDP rises to £1450 bn

In 2016, price index rises to 103

what is real gdp in 2016

Answer 14

= Nominal GDP x 100/price index in 2015 = £1,450 bn x 100/103

Real GDP = £1,408bn

(expressed at constant 2015 prices)

Question 15

How does the balance of the injections and withdrawals contribute to growth of the economy

Answer 15

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

whilst if injections are smaller than withdrawals, it will be shrinking.

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

Question 16

What matters in terms of AD shifts and macroeconomics equilibrium

Answer 16

What matters is whether total planned demand for goods and services (AD) is close to actual production from domestic and external sources.

Question 17

What is the effect of an outward shift in AD

Answer 17

An outward shift of aggregate demand will bring about a cyclical rise in output and employment.

Question 18

What is the effect of an outward shift in AD

Answer 18

An outward shift of aggregate demand will bring about a cyclical rise in output and employment.

Question 19

What is the impact of an increase in AS

Answer 19

An outward shift of aggregate supply e.g. caused by lower unit costs should help to increase business profits.

Question 20

What are the causes of an inward shift of LRAS

Answer 20

1. natural disasters such as drought.
2. Loss of factor inputs caused by forms of political conflict
3. Large scale net outward labour migration (brain drain)
4. A trend decline in productivity caused by a persistent recession

Question 21

What is the effect of increasing investment

Answer 21

• Increasing in demand for capital goods
• A boost to AD and also AS

Question 22

What are macro effects of a fall in AS

Answer 22

**Possible Macro Consequences
**
* May cause higher inflation

• May reduce real GDP growth
• May lead to lower profits, investment and employment
• May worsen the trade balance

Question 23

What is the liquidity trap

Answer 23

after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.

Question 24

Explain the movement from Point A –> B–> C

Answer 24

Shift of AD1 to AD2. In the short tun this will result in a movement up the
SRAS curve, output will rise from OY1 to OY2 and accompanied by a small rise
In the price level from OP1 to OP2. Moving the economy from A to B

The economy is now in long run disequilibrium. The full employment level is OY1. The economy is therefore operating at over-full employment. Firms will find it difficult to recruit labour, buy raw materials and find new offices/ factory space. Firms respond by bidding up wages

The SRAS curve is drawn on the assumption that wage rates and other costs remain constant so a rise in wage rates will shift upwards and the short run equilibrium will now fall and price will keep rising

The economy will now fall and keep rising. The economy will only return to long run equilibrium when the short tun aggregate supply curve has shifted upwards so that AD once again equals LRAS at C

Question 25

Explain the movement from A --> C using investment expenditure

Answer 25

* An increase in the investment will increase the capital stock of the economy will initially shift the AD curve to the right from AD1 to AD2 * There will then be a movement along the SRAS curve from A to B, there is now long-run disequilibrium * When solved, the LRAS curve will then shift to the right from LRAS1 to LRAS2 * Long run equilibrium to be restored to C, there will also be a new SRAS curve because it is assumed that investment has reduced costs of production * It is below the original SRAS curve, it is below the original SRAS curve because it is assumed that investment has reduced costs of production

Question 26

Draw stagflation from a supply-side shock due to uk oil crisis 1979; crude prices double to 40$ a barel

Answer 26

Question 27

What demand side shock did Nigel Lawson cause in 1986-88

Answer 27

* 1986-88, the Chancellor of the Exchequer, Nigel Lawson, helped fuel a boom with low interest rates and income tax cuts. The Lawson boom saw rising inflation, to combat this the government raised interest rated from 7.5% in May 1988 to 15% in 1989 and kept them at this level for nearly a year * Combined with a high value of the pound, AD fell. As shown in Figure 14, this led to a recession with falling output and downward pressure on prices as the economy moved from A to B * All other things equal the economy would have returned to long-run equilibrium at C Downturn of 08-13 was caused by a banking crisis, cuasing lending by banking to fall sharply, along with a fall in confidence by consumers and businesses

Question 28

How do Keynsians differ with Classical economists with fiscal policy

Answer 28

Keynsians differ with Classical economist as they want demand side policy rather than supply side policy

Question 29

What is the multiplier process

Answer 29

* The multiplier effect occurs when there is new demand in an economy leads to an injection of more income into the circular flow of income, which leads to economic growth. * The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income. * It occurs since ‘one person’s spending is another person’s income’.

Question 30

What is the MPW (Marginal Propensity to Withdraw)

Answer 30

MPS (save) , MPT (tax) , MPM (import)

Question 31

What is the MPC (Marginal Propensity to Consume)

Answer 31

* A consumer’s marginal propensity to consume is the **proportion of each additional pound of household income that is spent. ** * The higher the MPC, the bigger the size of the multiplier.

Question 32

How do you calcuate the mulitplier

Answer 32

1/MPW or 1/(1-MPC)

Question 33

What are some factors that cause a **high multiplier value**

Answer 33

* Economy has plenty of spare capacity (negative output gap) to meet higher demand * Marginal propensity to import and tax is low * High propensity to consume any extra income (i.e. a low propensity to save)

Question 34

What are some factors that cause a **low multiplier value**

Answer 34

* Economy is close to it’s capacity limits e.g. during a boom phase * Propensity to import goods & services is high – extra demand leaks from circular flow * Higher inflation causes rising interest rates which then dampens other components of AD

Question 35

Why does a high multiplier value need spare capacity

Answer 35

If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output.

Question 36

How does the multiplier effect interact with a tax cut to cause an overall rise in AD

Answer 36

1. Firstly, if consumers maintain the same spending habits, they will have more disposable income left over to buy more goods. 2. Secondly, they may be encouraged to buy goods (especially expensive electrical goods) etc. because they are cheaper. herefore, in theory, a tax cut should boost consumer spending and this leads to an overall rise in AD. This means firms will get an increase in output encouraging an expansion of labour. (multiplier)

Question 37

What is the **negative multiplier effect**

Answer 37

negative multiplier effect occurs when an initial withdrawal of spending from the economy leads to knock-on effects and a bigger final fall in real GDP.

Question 38

What are the causes of the **negative multiplier effect**

Answer 38

It could be a decrease in injections: * Fall in C, I, X, G Or an increase in withdrawals from the circular flow. - T, I, S

Question 39

What limits a spiralling negative multiplier effect

Answer 39

* **Welfare state**. Unemployed received benefits from the government to maintain spending * Injection from abroad. One economy may experience a slump, but then see demand rise from abroad. * Withdrawals countered by **new injections**. Higher tax is a withdrawal from the circular flow and may cause a fall in demand. But, with higher tax, the government may spend more on investment. * **Monetary policy**. In response to falling demand, monetary authorities may cut interest rates to make borrowing cheaper and boost demand.

Question 40

What are key evaluations of the multiplier effect

Answer 40

* Injections cause **crowding out** * **Time lag** for full multiplier effect

Question 41

What are some factors that cause a **low multiplier value**

Answer 41

* Economy is close to it’s capacity limits e.g. during a boom phase * Propensity to import goods & services is high – extra demand leaks from circular flow * Higher inflation causes rising interest rates which then dampens other components of AD

Question 42

What is the liquidity trap

Answer 42

after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.

Question 43

What are the four key parts of the Circular Flow of Income Model and explain what they do

Answer 43

1. Households receive income through wages, investments and they then buy goods 2. Businesses hire factor inputs when making products for which they pay wages 3. Government collects taxes (T) to fund spending 4. The UK buys imports from other countries, (M) and overseas buy exports (X)