3.2.2 How the macroeconomy works: the circular fow of income, aggregate demand/aggregate supply analysis, and related concepts

Question 1

What data is used to measure the performance of an economy?

Answer 1

GDP (Gross domestic product) - measure of economic growth through national output which is all the goods and services produced by an economy

Question 2

Define boom, recession/slump and depression

Answer 2

Boom - high economic growth

Recession/slump - negative economic growth for 2 consecutive quarters

Depression - sustained economic downturn for years

Question 3

How is the change in GDP measured?

Answer 3

change in GDP / original GDP x 100 (%)

Question 4

Define nominal GDP

Answer 4

Figure unadjusted for inflation - misleading as it presents GDP being higher than it is

Question 5

What is real GDP per capita?

Answer 5

Indicates the standard of living in a country

Formula: total GDP / population

Question 6

Define GNP and GNI

Answer 6

GNP - (product) Total output of the citizens of a country whether or not they’re a resident

GNI - (Income) GDP + net income from abroad - investments and assets owned abroad minus income earned by foreigners on investments domestically

Question 7

Define real GDP

Answer 7

Value of GDP adjusted for inflation e.g. if the economy grew by 4% and inflation was 2%, real GDP is 2%

Question 8

What is the circular flow of income concept?

Answer 8

National output = national income = national expenditure

Question 9

Explain the circular flow of income

Answer 9

The economy is made up of firms and households

firms produce goods / services which makes up the national output

Households provide labor, land and capital that firms use to produce national output - money paid for these factors of production is the national income

Households spend the money they get from national income on goods/ services and the value of this spending is national expenditure

Question 10

What is full employment income?

Answer 10

At full employment, national income, output and expenditure = full employment income

Question 11

What is the difference between injections and withdrawals into the circular flow of income?

Answer 11

Injections: Exports, investments and gov spending

Withdrawals: Imports, savings, taxes

Question 12

When is there an equilibrium in the economy through the circular flow of income?

Answer 12

when injections = withdrawals

Question 13

What is the effect of changes in injections and withdrawals on national income?

Answer 13

injections > withdrawals - expenditure > output so firms will increase output so national output, income and expenditure increase

withdrawals > injections - output > expenditure so firms will reduce output so national output, income and expenditure will decrease

Question 14

What is the multiplier effect?

Answer 14

Due to an injection, the actual change in national income > initial injection
E.g. gov gives a firm money to invest in new machinery (gov spending) and this is used to pay households for land, labour and capital so the money given by the gov is an injection of new income into the circular flow. This will shift the AD curve to the right
Some of this money leaks out of the circular flow as withdrawals (savings, taxes and imports) and the remaining is spent on goods and services so this goes back to the firms as expenditure increasing output.
Some more money leaks out of the circular flow as withdrawals from firms and the rest is paid as income to households.
This cycle continues until nothing of the initial investment is left but the original gov money has gone around the circular flow multiple times with some of it leaking out at each stage so the total effect of the investment on national output, income and expenditure is more than the initial
AD shifts even further to the right and the bigger the multiplier the greater the shift
Size of the multiplier depends on the size of leakages but its difficult to measure with time lags and can take years to show up in an economy

Question 15

Define wealth

Answer 15

Total value of all the assets owned by individuals or firms in an economy

Question 16

Define aggregate demand

Answer 16

Total demand / spending in an economy over a given period of time

Question 17

What is the formula for AD?

Answer 17

AD = C + I + G + (E -M)
consumption + investment + government spending + (exports - imports)

Question 18

What are the various factors that shift the AD curve and the SRAS curve? Consumption and savings

Answer 18

(1) Income
(2) Interest rates - when high, consumers save more to take adv of the higher rates and borrow less as its more expensive
(3) Consumer confidence - e.g. recession
(4) wealth effects - house price
(5) taxes
(6) unemployment

WUCITI

Question 19

Define investment

Answer 19

Money spent by firms on assets which they’ll use to produce goods / services such as machinery

Question 20

What are the factors that affect investment?

Answer 20

(1) risk - economic instability
(2) Government incentives and regulations - subsidies and taxes
(3) Access to credit - interest
(4) technical advances - competitiveness
(5) Business confidence - profit

BRATG

Question 21

Define consumption

Answer 21

Total amount spent by households on goods / services
Largest component of AD makes around 65% of AD in the UK economy

Question 22

Define government spending

Answer 22

Money spent by the government on public goods / service
Only includes that which contributes to the output of an economy not benefit’s and pensions

Question 23

How do the government influence AD?

Answer 23

low AD and slow economic growth makes the government overspend causing a budget deficit to increase AD and boost economic growth (injection)

high AD in a boom makes the government increase taxes and spend less causing a budget surplus to reduce AD and slow economic growth (withdrawal)

This is known as the fiscal policy

Question 24

What are the factors that affect imports and exports?

Answer 24

(1) Exchange rate - value of currency

strong currency worsens net exports in the LR as AD decreases as imports are cheaper so demand for them rises and exports are more expensive so demand for them decreases

(2) Changes in the state of the world economy - higher real income means more imports

(3) Quality of goods - exports increase

Question 25

What is meant by the average propensity and it’s formula?

Answer 25

Proportion of the total national income that’s spent or saved

Formula: consumption or amount saved / total income

Question 26

What is meant by the marginal propensity to consume / save and its formula?

Answer 26

Proportion of any extra income that’s spent on the consumption / savings of goods / services

Formula: change in consumption or savings / change in income

Question 27

What is the formula for calculating the multiplier?

Answer 27

1 / 1- MPC

Question 28

Define aggregate supply

Answer 28

Total output produced in an economy at a given price level over a given time

Question 29

What does the Classical LRAS diagram show?

Answer 29

The economy is moving to an equilibrium where all the resources are being used to its full capacity - economy is running at its full productive potential - vertical, an increase in PL won’t create more output as the economy is running at its full capacity

Question 30

What causes the SRAS curve shift?

Answer 30

Changes in the PL and cost of production (money wage rates, raw material prices, business taxation and productivity)
Supply side shock - natural disaster / war

Question 31

What causes the LRAS curve to shift?

Answer 31

Increased Factors of production as this increases capacity of the economy
(1) Improvement in education and skills - productivity
(2) better healthcare so less time off work and retire at old age
(3) Increasing factor mobility
(4) Improvements in a countries banking system - borrow money to invest
(5) Technology

THEFB

Question 32

What is the basic accelerator process?

Answer 32

When national income grows rapidly, businesses need to invest heavily so firms make accelerated investment in capital goods expecting to increase output and make profit in the future
this works with the multiplier

Question 33

What does the Keynesian LRAS diagram show?

Answer 33

At low levels of output, AS is completely elastic so there’s spare capacity in the economy, so output rises without a rise in the PL.

When it begins to slop, the economy is going through problems with supply (bottleneck) which causes an increase in cost

The curve becomes vertical when the economy is at full capacity and AS is completely inelastic. Resources are being used to their maximum potential so output can’t increase any more

Question 34

How does a shift in AS affect all the macroeconomic objectives?

Answer 34

Increase in AS leads to 1 increase in capacity of the economy, 2 increase in output, 3 increased economic growth. 4 More jobs which 5 reduces unemployment and 6 PL will fall which leads to 7 more competition 8 improving the balance of payments

COGJUFCB