2.5.2 circular flow of income, expenditure and output Flashcards
What is the circular flow of income?
The interaction of firms and households, exchanging resources in an economy.
What do households supply firms with?
The factors of production, such as labour an capital in return for wages and dividends.
What do firms supply to households?
Goods and services, which are paid for by consumers.
What are some withdrawals in the circular flow of income? [3]
- Saving
- Taxes
- Imports
What are some injections into the circular flow of income? [3]
- Government spending
- Exports
- Investment
When does an economy reach a state of equilibrium?
When the rate of withdrawals = the rate of injections.
What is important to remember when considering circular flow?
That income = output = expenditure
What is an injection into the circular flow of income?
Money which enters the economy.
What is a withdrawal in the circular flow of income?
Money which leaves the economy.
What happens if there are net injections into the economy?
There will be an expansion of national output.
What happens if there are net withdrawals from the economy?
There will be a contraction of production, so output decreases.
What is aggregate demand?
The total demand in the economy.
What does AD measure?
Spending on goods and services by consumers, firms, the government and overseas consumers and firms.
What is the equation for aggregate demand?
C + I + G + (X-M)
What are the components of aggregate demand? [4]
- Consumer spending
- Investment
- Government spending
- Exports minus imports
How much of GDP does consumer spending make up?
Just over 60% of GDP and is the largest component of aggregate demand.
What is disposable income?
The amount of income consumers have left over after taxes and social security charges have been removed. It is what consumers can choose to spend.
Where might consumer income generate from? [5]
- Wages
- Savings
- Pensions
- Benefits
- Investments
How do interest rates influence consumer spending?
If the MPC lower interest rates, it is cheaper to borrow and reduces the incentive to save, so spending and investment increase.
Lower interest rates also lower the cost of debt, such as mortgages.
Why is changing interest rates not suitable if a rise in AD is needed immediately?
There are time lags between the change in interest rates and the rise in AD.
How does consumer confidence impact consumer spending?
If consumers and firms have higher confidence levels, they invest and spend more because they feel as though they will get a higher return on them. This is affected by anticipated income and inflation.
If consumers fear unemployment or higher taxes, consumers may feel less confident about the economy, so they are likely to spend less and save more.
How much of GDP does capital investment account for?
15-20% of GDP in the UK per annum. 3/4 comes from private sector firms whilst the other 1/4 is spent by the government.
How much of AD does capital investment take up?
It is the smallest component of AD.
What influences are there on investment? [6]
- Rate of economic growth
- Business expectations and confidence
- Demand for exports
- Interest rates
- Access to credit
- Influence of government and regulations
How does the rate of economic growth influence investment?
If growth is high, firms will be making more revenue due to higher rates of consumer spending. This means they have more profits available to invest.
How do business expectations and confidence influence investment?
If firms expect a high rate of return, they will invest more. They need to be certain about the future.
How does demand for exports influence investment?
It is related to the rate of market demand. The higher demand there is, the more likely it is that firms will invest. This is because they expect higher sales, so they might direct capital goods into markets where consumer demand is increasing.
How do interest rates influence investment?
Investment increases as interest rates fall, as it means cost of borrowing is less and return to lending is higher.
The higher interest rates are, the greater the opportunity cost of not saving the money.
High interest rates might make firms expect fall in consumer spending, which discourages investment.
How does access to credit influence investment?
If banks and lenders are unwilling to lend, such as shortly after the financial crisis in 2008, firms will find it harder to gain funds for investment.
However, firms could use retained profits. Availability of funds is dependent on the level of saving in the economy.
How do government regulations influence investment?
The rate of corporation tax could affect investment. Lower taxes means firms keep more profits, which could encourage investment.
How much of GDP does government spending account for? Why are transfer payments not included in the figure?
18-20%.
This is due to the fact there is no output derived from transfer payments.
How much of AD does government account for?
It is the 3rd largest component of AD.
What influences are there on government expenditure? [2]
- Economic growth
- Fiscal policy
How does economic growth influence government expenditure?
During recessions, governments might increase spending to try and stimulate the economy. This will increase the government deficit, and the may have to finance this.
What does fiscal policy involve?
Changing government spending and taxation to control the economy.
What type of policy is fiscal policy?
It is a demand-side policy, so it works by influence the level or composition of AD.
What is discretionary fiscal policy?
Is a policy which is implemented through one of policy changes.
When may government use expansionary fiscal policy?
During periods of economic decline, with the aim to stimulate the economy by increasing government spending, decreasing taxes or a combination of both.
It ultimately leads to increased AD.
When may governments use contractionary fiscal policy?
During periods of economic growth, where it aims to slow down an over-heating economy by decreasing aggregate demand.
Tax rates may increase, but this reduces the size of the government budget deficit.
What does a positive value on the balance of payments indicate?
A surplus, whilst a negative indicates a deficit.
What is the UK’s balance of payments?
Has a relatively large trade deficit, which reduces the value of AD.
How much of AD does the balance of payments account for?
It is the 2nd largest component of AD.
What are the main influences on the net trade balance? [5]
- Real income
- Exchange rates
- State of the world economy
- Degree of protectionism
- Non-price factors
How does real income affect trade balance?
When consumers have higher incomes, they can afford to consumer more and so there is a large deficit on the current account.
When consumers increase their spending, they consumer more domestic products as well as more imports.
During economic decline, real incomes fall and previously this has led to improvements in the UK’s current account.
How do exchange rates influence the balance of payments?
A depreciation of the pound means imports are more expensive and exports are cheaper, and so the current account trade deficit narrows.
Depreciations make the currency relatively more competitive against other currencies.
How does the state of the world economy influence balance of payments?
A decline in economic growth in one of the UK’s export markets means there will be a fall in exports, due to decreased consumer spending in those economies because of falling real incomes.
What is the UK’s largest export market?
The EU.
How does protectionism influence trade balance?
If the UK employed several protectionist measures, then the trade deficit will reduce as they will be importing less due to tariffs and quotas on imports to the UK.
However, protectionism leads to retaliation and so exports might decrease too, undoing the effect of reduce imports.
When does the AS curve shift?
When there are changes in the conditions of supply.
What are the main determinants of Short Run Aggregate Supply?
Price level and production costs.
What could shift the AS curve? [5]
- Cost of employment might change e.g. wages, taxes and labour productivity.
- Cost of other inputs e.g. raw materials, commodity prices and the exchange rate
- Government regulation or intervention, such as environmental laws or green taxes and business regulation
- Could be a net outward migration of workers, which causes ‘brain drain’ on the domestic economy
- If there is fall in business capital spending, supply will fall
