4.2.2 How the Macroeconomy Works, Circular Flow of Income, AD/AS Analysis and Related Concepts

Question 1

Define National Income

Answer 1

National income is the total value of the goods and services a country produces. It is the output in one year.
It can be measured by GDP, GNP and GNI.

Question 2

Give a supporting diagram of the Circular flow of income

Question 3

Describe the Circular flow of Income

Answer 3

• Firms and households interact and exchange resources in an economy.
• Households supply firms with the factors of production, such as labour and capital, and in return, they receive wages and dividends.
• Firms supply goods and services to households. Consumers pay firms for these.
• This spending and income circulates around the economy in the circular flow of income, which is represented in the diagram above

Question 4

Define injections and give a real examples in the circular flow of income

Answer 4

A withdrawal from the circular flow of income is money which leaves the economy. This can be from taxes, saving and imports.

Saving income removes it from the circular flow. This is a withdrawal of income.

Question 5

Define exports in the circular flow of income

Answer 5

Exports are an injection into the economy, since goods and services are sold to foreign countries and revenue in earned from the sale.

Question 6

Define Imports in the circular flow of income

Answer 6

Imports are a withdrawal from the economy, since money leaves the country when goods and services are bought from abroad

Question 7

Define injections and give a real examples in the circular flow of income

Answer 7

An injection into the circular flow of income is money which enters the economy. This is in the form of government spending, investment and exports.

Taxes are also a withdrawal of income, whilst government spending on public and merit goods, and welfare payments, are injections into the economy.

Question 8

Define full employment income

Answer 8

Full employment income is the total output of an economy when unemployment is minimised or is at the government target. This accounts for frictional
unemployment.

Question 9

Define what is meant by the net injections of the economy

Answer 9

If there are net injections into the economy, there will be an expansion of national output.

Question 10

Define what is meant by the net withdrawal of the economy

Answer 10

If there are net withdrawals from the economy, there will be a contraction of production, so output decreases.

Question 11

Define aggregate demand

Answer 11

Aggregate demand is the total demand in the economy. It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms

Question 12

Give a supporting diagram of Moving along the AD curve and explain graph

Answer 12

A fall in the price level from P1 to P2 causes an expansion in demand from Y1 to Y2.
A rise in the price level from P2 to P1 causes a contraction in demand from Y2 to Y1.
Changes in the price level cause movements along the demand curve.

Question 13

Outline what is meant by a downward shift in the AD curve

Answer 13

The downward slope of the AD curve can be explained by:

• Higher prices lead to a fall in the value of real incomes, so goods and services become less affordable in real terms.
• If there was high inflation in the UK so that the average price level was high, foreign goods would seem relatively cheaper. Therefore, there would be more imports, so the deficit on the current account might increase, and AD would fall.
• High inflation generally means the interest rates will be higher. This will discourage spending, since saving becomes more attractive and borrowing becomes expensive.

Question 14

Outline and give a supporting diagram of a shift in the AD curve

Answer 14

A rise in AD is shown by a shift to the left in the demand curve (AD1 > AD2). This rise in economic growth occurs when:

• Consumers and firms have higher confidence levels, so 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 the Monetary Policy Committee lowers interest rates, it is cheaper to borrow and reduces the incentive to save, so spending and investment increase. However, there are time lags between the change in interest rates and the rise in AD, so this is not suitable if a rise in AD is needed immediately.
• Lower taxes mean consumers have more disposable income, so AD rises.
• An increase in government spending will boost AD.
• Depreciation in a currency means M is more expensive, and X is cheaper, so AD increases. A decline in economic growth in one of the UK’s export markets means there will be a fall in X, so AD falls.
• In the UK, most people own their houses. This means that a rise in the price of houses makes people feel wealthier, so they are likely to spend more. This is the wealth effect.

Question 15

Briefly describe the AS curve

Answer 15

1. Aggregate supply shows the quantity of real GDP which is supplied at difference price levels in the economy.
2. The AS curve is upward sloping because at a higher price level, producers are willing to supply more because they can earn more profits.

Question 16

The factors which affect long-run AS distinguish them from those which affect short run AS

Answer 16

The short run aggregate supply curve (SRAS) only covers the period immediately after a change in the price level. It shows the planned output of an economy when prices change, whilst the cost of production and productivity of the factor inputs are kept constant. These could be wage rates or how technologically advanced capital is, for example.

The curve is upward sloping because supply is assumed to be responsive to a change in AD, which is reflected in the price level

Question 17

Outline long run aggregate supply curve (LRAS)

Answer 17

• The long run aggregate supply curve (LRAS) shows the potential supply of an economy in the long run. This is when prices, and the costs and productivity of factor inputs, can change. Similarly to the PPF, it can show the economy’s productive potential.
• The curve is vertical, because supply is assumed not to change as the price level changes.
• A right-ward shift in the LRAS curve shows economic growth

Question 18

Define Macroeconomic equilibrium

Answer 18

The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections. This is equivalent to the point where AD = AS.

Question 19

Define aggregate demand

Answer 19

Aggregate demand is the total demand in the economy. It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.

Question 20

Define the equation of aggregate demand

Answer 20

It is made up of the following components, which make up the equation: C + I + G +(X-M)

Question 21

Define Disposable income

Answer 21

Disposable income is 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.

Consumer income might come from wages, savings, pensions, benefits and investments, such as dividend payments.

Question 22

Define the marginal propensity to consume

Answer 22

A consumer’s marginal propensity to consume is how much a consumer changes their spending following a change in income.

Question 23

Define the marginal propensity to save

Answer 23

A consumer’s marginal propensity to save is the proportion of each additional pound of household income that is used for saving.

Question 24

Outline the interest rates as a influence on consumer spending

Answer 24

If the Monetary Policy Committee lowers interest rates, it is cheaper to borrow and reduces the incentive to save, so spending and investment increase. However, there are time lags between the change in interest rates and the rise in AD, so this is not suitable if a rise in AD is needed immediately. Lower interest rates also lower the cost of debt, such as mortgages. This increases the effective disposable income of households.

Question 25

Outline the Consumer confidence as a influence on consumer spending

Answer 25

Consumers and firms have higher confidence levels, so 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. This delays large purchases, such as houses or cars.

Question 26

Define capital investment

Answer 26

This accounts for around 15-20% of GDP in the UK per annum, and about ¾ of this comes from private sector firms. The other ¼ is spent by the government on, for example, new schools. This is the smallest component of AD

Question 27

Outline the rate of economic growth as the influence of investment

Answer 27

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.

Question 28

Outline the business expectation and confidence as the influence of investment

Answer 28

• If firms expect a high rate of return, they will invest more. Firms need to be certain about the future, otherwise they will postpone their investments.
• Also, expectations about society and politics could affect investment. For example, if a change in government might happen, or if commodity prices are due to rise, businesses may postpone their investment decisions.
• Keynes coined the term animal spirits when describing instincts and emotions of human behaviour, which drives the level of confidence in an economy

Question 29

Outline the demand for exports as the influence of investment

Answer 29

This is related to the rate of market demand. The higher demand is, the more likely it is that firms will invest. This is because they expect higher sales, so they might direct capital goods into the markets where consumer demand is increasing.

Question 30

Outline the Interest rates as the influence of investment

Answer 30

• Investment increases as interest rates falls. This means that the cost of borrowing is less and the return to lending is higher.
• The higher interest rates are, the greater the opportunity cost of not saving the money.
  Moreover, high interest rates might make firms expect a fall in consumer spending, which is likely to discourage investment.

Question 31

Outline the access to credit as the influence of investment

Answer 31

If banks and lenders are unwilling to lend, such as shortly after the financial crisis when banks became more risk averse, firms will find it harder to gain access to credit, so it is either more expensive or not possible to gain the
funds for investment.

Firms could use retained profits, however. The availability of funds is dependent on the level of saving in the economy. The more consumers are saving, the more available fund are for lending, and therefore for investing.

Question 32

Outline the accelerator process

Answer 32

• The accelerator effect suggests that the level of investment in an economy is related to the change in GDP. A higher rate of economic growth causes more investment.
• If the rate of economic growth is slowing, but the economy is still growing, the level of investment might fall.
• The level of investment is more volatile than the rate of economic growth.

Question 33

Outline government spending as a determinants of government spending

Answer 33

This is how much the government spends on state goods and services, such as schools and the NHS. It accounts for 18-20% of GDP. Transfer payments are not included in this figure, because no output is derived from them,
and it is simply a transfer of money from one group of people to another. Government spending is the third largest component of AD

Question 34

Give a supporting diagram and explain the trade cycle

Answer 34

This is another term for the business cycle, which refers to the stage of economic growth that the economy is in. The economy goes through periods of booms and busts.

Real output increases when there are periods of economic growth. This is the recovery stage.
* The boom is when economic growth is fast, and it could be inflationary or unsustainable.
* During recessions, there real output in the economy falls, and there is negative economic growth.
* During recessions, governments might increase spending to try and stimulate the economy. This could involve spending on welfare payments to help people who have lost their jobs, or cutting taxes.
* This will increase the government deficit, and they may have to finance this.
* During periods of economic growth, governments may receive more tax revenue since consumers will be spending more and earning more. They may decide to spend less, since the economy does not need stimulating, and fewer people will be claiming benefits.

Question 35

Briefly describe fiscal policy as an influence on government expenditure

Answer 35

Governments use fiscal policy to influence the economy. It involves changing government spending and taxation

• Governments might spend on public goods and merit goods, as well as welfare payments.
• Fiscal policy is a demand-side policy, so it works by influencing the level or composition of AD.

Question 36

Define Discretionary fiscal policy

Answer 36

Discretionary fiscal policy is a policy which is implemented through one-off policy changes.

Question 37

Define Automatic stabilisers in the fiscal policy

Answer 37

Automatic stabilisers are policies which offset fluctuations in the economy. These include transfer payments and taxes. They are triggered without
government intervention.

Question 38

Outline the different types of fiscal policy

Answer 38

The government might use expansionary fiscal policy during periods of economic decline. This involves increasing spending on transfer payments or on boosting AD, or by reducing taxes.

During periods of economic growth, governments might use contractionary fiscal policy by decreasing expenditure on purchases and transfer payments. Additionally, tax rates might increase. This reduces the size of the government budget deficit.

Question 39

Outline Real income as an influence on trade balances

Answer 39

• During periods of economic growth, when consumers have higher incomes and they can afford to consume more, there is a larger deficit on the current account.
• When consumers increase their spending, they consume more domestic products as well as more imports.
• During periods of economic decline, real incomes fall and historically, this has led to improvements in the UK’s current account.

Question 40

Outline Exchange rates as an influence on trade balances

Answer 40

• A depreciation of the pound means imports are more expensive, and exports are cheaper, so the current account trade deficit narrows.
• Depreciations make the currency relatively more competitive against other currencies.
• However, it depends on which currency the pound depreciates against. If it is the dollar or euro, it is likely to have a more significant effect, than a currency which is not from one of the UK’s major trading partners.
• Moreover, the demand for UK exports has to be price elastic to lead to an increase in exports. If demand is price inelastic, exports will not increase significantly, and the value of exports will decrease.

Question 41

Outline State of the World Economy as an influence on trade balances

Answer 41

• A decline in economic growth in one of the UK’s export markets means there will be a fall in exports. This is because consumer spending in those economies will fall, due to falling real incomes.
• For example, the UK’s largest export market is the EU. If they face an economic downturn then demand for UK goods and services will fall, since consumers in the EU are less able to afford imports.

Question 42

Outline Degree of protectionism as an influence on trade balances

Answer 42

• Protectionism is the act of guarding a country’s industries from foreign competition. It can take the form of tariffs, quotas, regulation or embargoes.
• If the UK employed several protectionist measures, then the trade deficit will reduce. This is because the UK will be importing less due to tariffs and quotas on imports to the UK.
• However, since protectionism leads to retaliation, exports might decrease too, which undoes the effect of reduced imports.

Question 43

Outline Non-price factors as an influence on trade balances

Answer 43

The competitiveness of a country’s goods and services, which is influenced by supply-side policies, impacts how many exports the country has.
o A country can become more competitive by being innovative, having higher quality goods and services, operating in a niche market, having lower labour costs, being more productive or by having better infrastructure. These increase exports.
o Moreover, trade deals and being part of trading blocs can influence how much a country exports. This either opens up a country to, or closes a country from, significant export opportunities.

Question 44

Give a supporting diagrams and outline factors influencing short run AS

Answer 44

The SRAS curve shifts when there are changes in the conditions of supply.The price level and production costs are the main determinants of SRAS.

The cost of employment might change, e.g. wages, taxes, and labour productivity. If costs increase, supply will shift inwards from SRAS1 to SRAS3.
* The cost of other inputs e.g. raw materials, commodity prices, and the exchange rate if products are imported. A stronger currency reduces the price of imports, so imported products will be cheaper. This would shift the AS curve outwards, from SRAS1 to SRAS2.
* Government regulation or intervention, such as environmental laws or green taxes and business regulation. Business regulation is sometimes called ‘red tape’.
* There could be a net outward migration of workers, which causes a ‘brain drain’ on the domestic economy, as skilled workers move elsewhere.
* If there is a fall in business capital spending, supply will fall.

Question 45

Outline factors influencing long run AS

Answer 45

The LRAS curve is influenced by changes which affect the quantity or quality of the factors of production. This is equivalent to shifting the PPF curve i.e. when the economy is operating at full capacity.

• Changes in relative productivity: A more productive labour and capital input will produce a larger quantity of output with the same quantity of input.
• Changes in education and skills: This improves the quality of human capital, so it is more productive and more able to produce a wider variety of goods and services.
• Changes in government regulations: Government regulation could limit how productive and efficient a firm can be if it is excessive. This is sometimes referred to as ‘red-tape’.
• Demographic changes and migration: If there is net inward migration and the majority of the population is of working age, the size of the labour force is going to be significant, which means the economy can increase its output.
• Competition policy: A more competitive market encourages firms to be more efficient and more
  productive, so they are not competed out of business. Governments can use effective competition policy to stimulate this in the economy.

Question 46

Give an example and outline the Keynesian AS curve

Answer 46

The Keynesian view suggests that the price level in the economy is fixed until resources are fully employed. The horizontal section shows the output and price level when resources are not fully employed; there is spare capacity in the economy.
The vertical section is when resources are fully employed.
Over the spare capacity section, output can be increased (AD1 to AD2) without affecting the price level (stays at P1). In other words, output changes are not inflationary.
Once resources are fully employed, an increase in output (AD3 to AD4) will be inflationary (price level increases from P2 to P3).