3.2.2 How the macroeconomy works: the circular fow of income, aggregate demand/aggregate supply analysis, and related concepts Flashcards
What data is used to measure the performance of an economy?
GDP (Gross domestic product) - measure of economic growth through national output which is all the goods and services produced by an economy
Define boom, recession/slump and depression
Boom - high economic growth
Recession/slump - negative economic growth for 2 consecutive quarters
Depression - sustained economic downturn for years
How is the change in GDP measured?
change in GDP / original GDP x 100 (%)
Define nominal GDP
Figure unadjusted for inflation - misleading as it presents GDP being higher than it is
What is real GDP per capita?
Indicates the standard of living in a country
Formula: total GDP / population
Define GNP and GNI
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
Define real GDP
Value of GDP adjusted for inflation e.g. if the economy grew by 4% and inflation was 2%, real GDP is 2%
What is the circular flow of income concept?
National output = national income = national expenditure
Explain the circular flow of income
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
What is full employment income?
At full employment, national income, output and expenditure = full employment income
What is the difference between injections and withdrawals into the circular flow of income?
Injections: Exports, investments and gov spending
Withdrawals: Imports, savings, taxes
When is there an equilibrium in the economy through the circular flow of income?
when injections = withdrawals
What is the effect of changes in injections and withdrawals on national income?
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
What is the multiplier effect?
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
Define wealth
Total value of all the assets owned by individuals or firms in an economy
Define aggregate demand
Total demand / spending in an economy over a given period of time
What is the formula for AD?
AD = C + I + G + (E -M)
consumption + investment + government spending + (exports - imports)
What are the various factors that shift the AD curve and the SRAS curve? Consumption and savings
(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
Define investment
Money spent by firms on assets which they’ll use to produce goods / services such as machinery
What are the factors that affect investment?
(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
Define consumption
Total amount spent by households on goods / services
Largest component of AD makes around 65% of AD in the UK economy
Define government spending
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
How do the government influence AD?
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
What are the factors that affect imports and exports?
(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
What is meant by the average propensity and it’s formula?
Proportion of the total national income that’s spent or saved
Formula: consumption or amount saved / total income
What is meant by the marginal propensity to consume / save and its formula?
Proportion of any extra income that’s spent on the consumption / savings of goods / services
Formula: change in consumption or savings / change in income
What is the formula for calculating the multiplier?
1 / 1- MPC
Define aggregate supply
Total output produced in an economy at a given price level over a given time
What does the Classical LRAS diagram show?
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
What causes the SRAS curve shift?
Changes in the PL and cost of production (money wage rates, raw material prices, business taxation and productivity)
Supply side shock - natural disaster / war
What causes the LRAS curve to shift?
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
What is the basic accelerator process?
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
What does the Keynesian LRAS diagram show?
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
How does a shift in AS affect all the macroeconomic objectives?
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
