2.4 - national income Flashcards
2.4.1 - national income
circular flow of income?
-an economic model that illustrates money flows in an economy
what do households own?
- the wealth in the economy
what do households supply?
-Their factors of production to firms and receive income as a reward
They receive rent for land, wages for labour, interest for capital, and profit for enterprise
With this income, they purchase goods/services from firms
WHAT DO FIRMS DO?
purchase factors of production from households
They use these resources to produce goods/services
They sell the goods/services to households and receive sales revenue
National income is the value of the output of an economy over a period of time
It can be calculated using the income approach or expenditure approach
Expenditure = income
income?
a flow in the economy, whereas wealth is a stock of assets that can be used to generate income
injections?
-exports
-gov spending
-investments
increases AD
increase size of circular flow of income
withdrawals?
-import
-taxes
-savings
decreases AD
how does The relative size of the injections and withdrawals impacts the size of the economy?
Injections > withdrawals = economic growth
Withdrawals > injections = fall in real GDP
Injections represent…?
new income in the economy
the multiplier effect?
-can cause the economy to grow by a greater amount than the size of the injection
what will cause increase/decrease the relative size of the circular flow of income?
-Changes to any of the factors that influence government spending, investment, consumption and net exports
2.4.3 - Equilibrium levels of
real national output
Real national output equilibrium occurs…?
where aggregate demand intersects with aggregate supply
According to classical theory?
[classical SRAS]
this economy is in short run equilibrium at AP1Y1
Any changes to the components of AD will cause the AD curve to shift left or right creating a new short-run equilibrium
Any changes to the determinants of SRAS will shift the SRAS curve left or right creating a new short-run equilibrium
LRAS- classical economists
believe that the economy will always return to its full potential level of output and all that will change in the long-run, is the average price level
LRAS -Keynesian economists
believe that the economy can be in long-run equilibrium at any level of output
A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) and aggregate demand (AD)
The LRAS curve demonstrates the maximum possible output of an economy using all of its scarce resources
The SRAS intersects with AD at the LRAS curve
This economy is producing at the full employment level of output (YFE)
The average price level at YFE is AP1
A diagram that shows the Keynesian view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS) and aggregate demand (AD)
The vertical portion of the LRAS curve corresponds to the classical view of LRAS
The Keynesian view believes there is a maximum level of possible output
The LRAS curve becomes elastic at a certain price level as prices cannot fall further
Possibly due to minimum wage laws, the existence of trade unions, or long-term employment contracts preventing wage decreases
Real output national equilibrium can occur at any level of output
In this case equilibrium is at the intersection of LRAS and AD (AP1Y1)
Changes in the Equilibrium Price Level & Real National Output [ classical approach ]
-increase in AD
-increase in AS
-
An increase in Aggregate Demand (AD) [classical]
-The initial equilibrium level of output was at AP1Y1
An increase in one of the components of AD (e.g. consumption) causes the AD to increase AD1→AD2
Average prices in the economy rise to AP2 and the real level of output increases to Y2
The new short-run equilibrium is at AP2Y2
A diagram showing the Classical representation of an increase in the short-run aggregate supply (SRAS)
-The initial equilibrium level of output was at AP1Y1
This equilibrium represents a recessionary or negative output gap equal to Y1YFE
An increase in one of the determinants of SRAS (e.g. productivity) causes the SRAS to increase SRAS1→SRAS2
Average prices in the economy fall to AP2 and the real level of output increases to Y2
The new short-run equilibrium is at AP2Y2
There is still a negative output gap but it is smaller (Y2YFE)
A diagram that illustrates the Keynesian view of how changes to aggregate demand (AD) have different impacts on the average price level (AP
The economy is initially in equilibrium at the intersection of AD1 and LRAS
The price level is AP1 and the output is at Y1
An increase in any component of AD (e.g. government spending) causes AD to shift from AD1→AD2
As this increase occurs close to the full employment level of output, there is a large increase in the average price level (AP1→AP2), but a relatively small increase in real output (Y1→Y2)
A decrease in any component of AD (e.g. net exports) causes AD to decrease from AD1→AD3
As this decrease occurs close to the elastic portion of the LRAS curve, there is a relatively larger decrease in the real output (Y1→Y3) than the decrease in the average price level (AP1→AP3)
If a further decrease in AD were to take place from AD3→AD4, there would be virtually no impact on the average price level, but the real output would fall from Y3→Y4
A diagram showing the Classical view of an increase in the long-run aggregate supply (LRAS) of an economy and how it lowers average price levels
The initial potential output of this economy is seen at YFE
The economy is in equilibrium at AP1YFE
A change to the education level in the economy can increase the quality of labour and shift the LRAS to the right from LRAS1→LRAS2
There is now an increased level of possible output in the economy YFE1
The extra supply in the economy allows prices to fall and output to increase resulting in a new equilibrium at AP2YFE1
A diagram showing the Keynesian view of an increase in the long-run aggregate supply (LRAS) of an economy and how it changes output without necessarily changing average price levels
The initial potential output of this economy is seen at YFE
The economy is in equilibrium at the intersection of AD1 and LRAS (AP1YFE)
A change to the immigration policy can increase the quantity of labour and shift the LRAS to the right from LRAS1→LRAS2
There is now an increased level of possible output in the economy YFE1
AD is in the vertical portion of the LRAS curve so output will increase (YFE→YFE1) and average prices will fall (AP1→AP3)
If the starting point of this economy had been the equilibrium at AD2Y2, then according to Keynesian thinking, an increase in LRAS would not impact the economy as it is stuck in a depression and requires AD to increase in order to change national output
2.4.4 – [the multiplier]
The multiplier ratio ?
is the ratio of change in real income to the injection that created the change
E.g. If the UK government injected an additional £5m into the economy through government spending and it resulted in an increase in real income of £15m, the value of the multiplier would be 3
what is the multiplier effect?
An initial change in aggregate demand can have a greater final impact on the level of equilibrium national income.
when does the multiplier effect occur?
when an initial injection into the circular flow causes a bigger final increase in real national income. This injection of demand might come for example from a rise in exports, investment or government spending.
when does the multiplier effect arises?
because one agent’s spending is another agent’s income. When a spending project creates new jobs for example, this creates extra injections of income and demand into a country’s circular flow.
The negative multiplier effect occurs when…?
when an initial withdrawal or leakage of spending from the circular flow leads to knock-on effects and a bigger final drop in real GDP.
The multiplier process is based on what?
based on the idea that one individual’s spending is another individual’s income
Multiplier process;
an increase in consumption immediately increases AD
An increase in consumption immediately increases AD
Store owners who have benefitted from the extra consumption now have extra income
They spend some of that income on goods/services
Their expenditure on goods/services is now income for the next tier of individuals
The size of the multiplier is entirely dependent on…?
the size of withdrawals or leakages that occur during the process
The higher the leakages the smaller the multiplier
The initial injection shifts AD to the right
?
The result of the multiplier process is that there is then a secondary movement of AD to the right which (if the multiplier were 2) may be double the initial movement
The multiplier can also work in reverse when…?
-when injections are reduced (downward multiplier effect)
The ‘marginal propensities’ refer to what?
- the proportion of the next additional $ earned that a consumer saves, consumes, is taxed, or purchases imports with
why are Marginal propensities calculated
Marginal propensities are calculated for economies and provide insights into how each additional $ of income is allocated
Marginal Propensity to Consume (MPC)
The proportion of additional income that is spent
Marginal Propensity to Save (MPS)
The proportion of additional income that is saved
Marginal Propensity to Tax (MPT)
The proportion of additional income that is paid in tax
Marginal Propensity to Import (MPM)
The proportion of additional income that is spent on imports
calculating the multiplier
The value of the multiplier can be calculated one of two ways
Focussing on the MPC
multiplier = 1 / 1- MPC
Focusing on the Withdrawals
multiplier= MPM + MPT + MPS
Significance of the Multiplier in Shifting AD
The greater the withdrawals, the smaller the value of the multiplier - and vice versa
The greater the MPC, the greater the value of the multiplier - and vice versa
Any change in one of the factors that impacts on disposable income, will change the multiplier
If taxes increase, the value of the multiplier reduces
If interest rates increase, savings increase and consumption decreases, and the multiplier reduces
If exchange rates appreciate, the level of imports will increase and the multiplier decreases
If confidence in the economy increases consumption increases and the multiplier increases
