2.4 National Income

Question 1

What is the multiplier ratio
Who created the theory

Answer 1

the ratio of a change in real income to the initial injection that brought it about

Created by Keynes

Question 2

What is the multiplier effect / process

Answer 2

When an injection into the circular flow of income eventually leads to an even bigger increase in national income than the value of the injection

Question 3

What is the effect of the multiplier on the economy

(And graph)

Answer 3

• initial injection (increased government spending, investment or exports) causes an increase in AD (AD1 to AD2)
• this causes an increase in the price level (P1 to P2) and an increase in Real GDP (Y1 to Y2)
• this injection then creates income for someone else (workers)
• those who receive increased income will spend a proportion of it in the economy and the rest will be withdrawn from the circular flow = determines the overall multiplier effect
• if proportion withdrawn isn’t 100%, there is a further increase in AD (AD2 to AD3) (consumer spending increases)
• causes price level to increase (P2 to P3) and real GDP to increase (Y2 to Y3)
• causes overall increase of economy from Y1 to Y3

Question 4

What are the marginal propensities

Answer 4

• marginal propensity to consume (MPC)
• marginal propensity to save (MPS)
• marginal propensity to tax (MPT)
• marginal propensity to import (MPM)

Question 5

The marginal propensity to consume (MPC)

Definition & formula

Answer 5

= proportion of extra income spent in the economy (on goods and services)

Question 6

The marginal propensity to save (MPS)

Definition & formula

Answer 6

= proportion of extra income that is saved

Question 7

The marginal propensity to tax (MPT)

Definition & formula

Answer 7

= proportion of extra income that goes to the government in the form of taxation

Question 8

The marginal propensity to import (MPM)

Definition & formula

Answer 8

= proportion of extra income spent on imports

Question 9

In what type of countries does MPC tend to be higher

Answer 9

= less developed countries

Generally, people with lower incomes tend to have higher MPCs, as spend any extra income they get when struggle to afford basics
But people with higher incomes able to save

Question 10

Marginal propensity to withdraw (MPW)

Definition & formula

Answer 10

= proportion of extra income withdrawn from the economy

MPW = MPS + MPT + MPM

MPW = 1-MPC

Question 11

The multiplier formula

Answer 11

Question 12

Significance of multiplier (marginal propensities) for shifts in AD

Answer 12

Greater MPC = greater multiplier effect = injections have larger impact on national income = greater increases in AD

Greater MPW (MPS, MPT, MPM) = smaller multiplier effect = injections have smaller impact on national income = smaller increase in AD

Question 13

Economic Factors that affect the multiplier

Answer 13

• large rise in interest rates = discourages consumption & encourages savings = fall in MPC, rise in MPS = fall in value of multiplier
• rise in household wealth = more disposable income = rise in MPC= rise in value of multiplier
• rise in gov taxes = rise in MPT, fall in MPC = fall in value of multiplier
• improvement in imported goods quality = households buy more imports = rise in MPM = fall in value of multiplier

Question 14

What determines the size of the change in equilibrium position of real national output when an AS or AD curve shifts

Answer 14

= size of the shift in AD/AS
= elasticity of the curve which hasn’t moved (PED/PES)

Question 15

National income

Answer 15

Value of output, expenditure, or income in an economy over a period of time

Question 16

Closed economy vs open economy

Answer 16

Closed economy = where there is no foreign trade, economy operating without imports & exports

Open economy = has low-tariff and non-tariff barriers so is deeply integrated into the regional & global economy

Question 17

Distinction between income & wealth

Answer 17

Income = flow of money obtained from factors of production (wages, interest, rent, profit)
Earned or received during limited period

Wealth = value/store of assets owned by household (property, shares, savings)
Accumulated over time (wealth often generates income eg. Interest payments, dividends, pension schemes)

Question 18

Types of income and what factors of production they are obtained from

Answer 18

Wages : labour
Interest : capital
Rent : land
Profit (dividends) : enterprise

Question 19

Circular flow of income model

Answer 19

Economic model that shows flow of goods & services & factors of production between firms & households

Circular as households supply firm with factors of production used to make goods/services then bought by households & firms spend this money on factor income (wages, rent, interest, dividends)

Question 21

What 3 ways of measuring the level of economic activity does the circular flow of income model shows

Answer 21

• National Output (O) = value of goods & services from firms to households
• National Expenditure (E) = value of spending by households on goods & services
• National Income (Y) = value of income paid by firms to households in return for land, labour & capital

O≡E≡Y

Question 22

Injections

Answer 22

Variables in an economy that add to the circular flow of income (money entering the economy)

• investment (I)
• government spending (G)
• exports (X)

Question 23

Withdrawals

Answer 23

Variables in an economy that remove money flows from the circular flow of income (money leaving the economy)

• savings (S)
• taxation (T)
• imports (M)

Question 24

Impact of injections & withdrawals on circular flow of income

Answer 24

injections = withdrawals (equilibrium) - national income remain the same

injections greater than withdrawals - national income will rise as amount of money in circular flow increases = economic growth

withdrawals greater than injections - national income will fall as amount of money in circular flow decreases = fall in GDP (negative economic growth)

When an initial injection is made into the circular flow, the actual change in the national income is > the initial injection

§ The size of the multiplier effect depends on the rate at which money leaks from the CFI e.g. the bigger the leakages the quicker money will leave the circular flow and the smaller the multiplier effect will be

§ So if lots of money being spent on imports (or used as savings or tax) then the multiplier effect will be quite small because the injection will quickly leak out of the circular flow.

Question 25

Impact of policy decision (interest rates) on circular flow (economic growth)

Answer 25

Decrease in interest rates:

• encourages investment from firms as reduced cost of borrowing so injections increase
• less incentive to save as less rewards so more consumer spending (reduction in savings so reduction in withdrawals)

Question 26

Concept of equilibrium real national output

Answer 26

• where AD = AS (curves intersect)

Equilibrium level of income & output = OY
Equilibrium price level = OP

Question 27

What will cause a shift to the right of an AD curve

Answer 27

An increase in any of the components of AD (C, I, G, X-M)

Eg. Fall in interest rates = raises consumption & investment
Eg. Fall in exchange rates = boost exports & reduce imports
Eg. Lower income tax = households have higher disposable income = raises consumption

Question 28

Difference between long run equilibrium for classical & Keynesian economists

Answer 28

Classical: LRAS curve (vertical) shows supply curve for economy at full employment = no unemployment in long run

Keynesian: LRAS curve (curved) shows supply curve for economy at different levels of employment in the long run
Economy can be at equilibrium at less than full employment

Question 29

Why are classical economist in favour of supply side policies but Keynesian economists in favour of demand side policies

Answer 29

According to classical model:

Increase in AD = same output, higher prices
Increase in LRAS = higher output, lower prices

So better for economy if LRAS increases (policies to increase supply)

According to Keynesian model:

Only an increase in AD will move an economy out of depression, increase in LRAS has no effect in a depression

So better for economy if AD increases (policies to increase demand)

Question 30

Effects of AD right shift on key macro-economic variables

Answer 30

Growth = increase (firms react to increase in demand by producing more goods/services = economic output increases = increase in real gdp = economic growth

Unemployment = decrease (labour is a derived demand from demand for goods & services, economic growth increases = greater demand for goods & services = greater demand for labour to produce goods & services)

Inflation = increase (more demand = more pressure on factors of production = increased factors of production)

Trade position = worsen (exports less competitive = demand for exports fall = reduced exports & bigger economy = more disposable income = increased demand for imports,
imports higher than exports = trade deficit)

Question 31

Effects of LRAS right shift on key macro-economic variables

Answer 31

Growth = increase (extension of AD = more demand for goods & services = firms produce more output for profit = economic growth)

Unemployment = decrease (labour is a derived demand from demand of goods & services, more growth = demand for labour increases)

Inflation = decrease (less competition for goods & services, as bigger economy so more factors of production available = reduced costs)

Trade position = improves (price level of economy falls = exports more competitive = demand for exports rises = exports higher than imports = trade surplus)

Question 32

Equilibrium real national output on classical model

Answer 32

Short run equilibrium at where AD = SRAS, gives price level P1 & output Y1 Can pass full employment level (YFE) through unsustainable use of factors of production (paying workers overtime) in short run (Y1-YFE = positive output gap) Can occur before full employment level (YFE) as factors of production not used efficiently (YFE-YE = negative output gap) In long run, wages become variable so economy adjusts to full employment level YFE (reduction in wage costs) (classical theory that economy will always be at full employment in long run) (AD=SRAS=LRAS)

Question 33

Equilibrium real national output on Keynesian model

Answer 33

Doesn’t differentiate between short run & long run Long run equilibrium can be at any point where AD=LRAS So policies focused on increasing AD to move economy closer to full employment level YFE Without expansionary policy in place, negative output gap (YFE-Y1) will exist in long run

Question 34

How shift in AD causes changes in equilibrium price level & real national output (classical model)

Answer 34

Increase in AD (AD1 to AD2) causes increase in real GDP (Y1 to YFE) moving economy (equilibrium) to full employment YFE Increase in AD causes price level to increase (P1 to P2) as reduction in spare capacity puts pressure on existing factors of production

Question 35

How shift in SRAS causes changes in equilibrium price level & real national output (classical model)

Answer 35

Decrease in costs of production causes SRAS to increase (SRAS1 to SRAS2) so increase in real GDP (Y1 to Y2) & decrease in price level (P1 to P2) as firms can offer lower prices But if decrease in SRAS firms pass increased cost of production onto customers as higher prices (Cost push inflation) to increase in price (P1 to P3) & decrease in real GDP

Question 36

How shift in LRAS causes changes in equilibrium price level & real national output (classical model)

Answer 36

Increase in LRAS causes increase in real GDP & decrease in cost push inflation Converse

Question 37

How shift in AD causes changes in equilibrium price level & real national output (Keynesian model)

Answer 37

Increase in AD causes increase in real GDP (Y1 to YFE) and increase in price level as increased pressure on existing factors of production caused by increase in demand as economy operates closer to/at full capacity Closer to full capacity = higher increase in price level as more pressure on existing factors of production

Question 38

How shift in LRAS causes changes in equilibrium price level & real national output (Keynesian model)

Answer 38

Increase in LRAS causes increase in real GDP & decease in general price level as increase in maximum potential production within economy so less pressure on existing factors of production as demand stays the same

Question 39

What are the limitations of using the multiplier when looking at its impact in practice?

Answer 39

It is difficult to measure the exact size of the multiplier. Sophisticated econometric models have been used which look at workings of the economy but they are not completely accurate. Equally changes can happen in the economy which can alter the size of the multiplier from one period to the next.

§ The multiplier effect is not instantaneous. A £100 increase in government spending does not increase the national income by £200 today. It takes time for money to flow around the circular flow, so there are time lags between the increase in the government spending and final increase in national income.

§ Economists disagree about the exact size of the multiplier, however in developed countries it is considered to be relatively low at around 0.5.

§ If AS is inelastic the impact of the multiplier is reduced – Keynesian and classical economist agree that when stimulating AD on the inelastic part of the AS curve – output won’t increase and the impact is purely inflationary.