4.2.2 - How The Macroeconomy Works : The Circular Flow Of Income , Aggregate Demand/ Aggregate Supply Analysis And Related Concepts Flashcards
Define and explain the circular flow of income
Draw it in a diagram
Shows connections between different sectors of an economy, shows flows of goods and services and factors of production between firms and households.
Explain Withdrawals in terms of the circular flow of income.
What do they include
Reduce the circular flow of income and leads to a multiplied contraction of production.
Includes:
Savings (bank accounts and deposits)
Government taxation (income tax and national insurance)
Imports (money leaves the country)
Explain Injections in terms of the circular flow of income
What do they include
Boost the circular flow of income and leads to a multiplied expansion of production.
Includes:
Consumer spending and firm investment
Government spending
Exports (money leaves the country)
Define National output
Is the value of the flow of goods and services from firms to households
Define National Expenditure
Is the value of spending by households on goods and services, from households to firms
Define a closed economy
Define a open economy
Is an economy where there is no foreign trade
Is an economy where there is trade with other countries
Explain the multiplier effect
Occurs when an initial injection into the economy results in the economy (GDP) growing by more than the size of the injection, kickstarts a chain of spending
Define consumption
Is spending by households on goods and services
State factors determining consumption (6)
Interest rates Consumer confidence Taxation Wealth Inflation Composition of households
Explain Interest rates as a factor determining consumption
If interest rates rise it reduces the desire of households to engage in credit financed consumption and increases the incentive to save, reducing consumption
Explain consumer confidence as a factor determining consumption
Households will have varying degrees of confidence about the future. If they feel that their incomes could fall they are likely to reduce consumption.
Explain taxation as a factor determining consumption
Changes in taxation will effect how much households have to spend. Increased taxes will lead to reduced overall consumption
Explain wealth as a factor determining consumption
If households wealth decreases, they will spend less on consumer goods and services
Explain inflation as a factor determining consumption
A rise in the general level of prices can lead to an erosion of wealth. Can lead to households saving more to recoup their wealth, reducing consumption.
Explain the Composition of households as a factor determining consumption
The more young and old the households the higher proportion of their incomes spent and therefore the greater consumption
Define Investment
Is the addition to the capital stock of the economy- factories, machines, offices and stocks of materials which are used to produce goods and services
Define Gross investment
Define Net investment
Measures investment before depreciation
Gross investment with the effects of depreciation
Define Physical capital
Define Human capital
Is investment into physical things like factories
Is investment into the education and training of workers
State the factors determining investment (8)
Interest rates Rate of economic growth Costs Business expectations and confidence World economy Access to credit Retained profit Influence of government regulation
Explain interest rates as a factor determining investment
Explain the liquidity trap
Interest paid on loans represents a cost of an investment project. As interest rates increase rates of investment are likely to decrease, as there is an increased cost of borrowing and increased benefit of saving
Liquidity trap occurs where there is a failure of monetary policy (interest rates) to influence levels of consumption and investment, due to banks not wanting to loan money and low consumer and business confidence
Explain the rate of economic growth as a factor determining investment
Explain the accelerator theory
If increased production levels are being produced each year, meaning GDP has risen, the level of investment will increase due to the need for an expansion in capacity.
The accelerator theory is the idea that levels of investment are proportionate to changes in the economy.
Explain costs as a factor determining investment
Increases in costs will reduce the profitability or rate of return from an investment. Whether the output from an investment will cover costs is important for a business when deciding whether to invest or not.
Explain Business expectations and confidence as a factor determining investment
If a firm expects sales to fall and loses confidence, they are likely to cut back on their investment
Explain the world economy as a factor determining investment
If the world economy is in a recession, demand for exports is likely to decrease. This will lead to a decrease in domestic investment, due to the knock on effects of overseas investment
Explain access to credit as a factor determining investment
Some investment is financed through borrowing. In a recession it becomes harder to borrow money as banks are less willing to give loans as they fear that firms will not be able to pay back the interest on loans
Explain retained profit as a factor determining investment
Most investment is financed from retained profits. If retained profits are low, firms will tend not to invest.
Define Government spending
Includes all government consumption, investment and transfer payments
Define current spending
Define capital spending
Is expenditure on day to day running costs from the government on wages of public sector workers and raw materials
Is investment in fixed assets, infrastructure or buying equipment
Explain what the significance of government debt depends on
Depends on who owns the debt, if it is owed to citizens it is less significant than debt owed to overseas firms and countries. Most of UK government debt is owed to citizens and UK firms
Define Direct Taxes
Define Indirect taxes
Taxes on wealth, income and profit. Includes income tax, inheritance tax and corporation tax. Its burden cannot be passed on.
Taxes imposed on producers. Include excise duty for cigarettes and alcohol and VAT. It’s burden can be passed on to consumers
Define Progressive Taxes
Define Regressive Taxes
Occurs where the marginal rate of tax rises as income rises. E.g. Income Tax
Occurs where the marginal rate of tax decreases as income rises. E.g. National Insurance
Define a Fiscal Deficit
Define a Fiscal Surplus
Occurs where government spending is greater than taxation
Occurs where government spending is less than taxation
Define the current account balance of payments
What does it consist of (deficit or surplus)
Measures financial transactions between the UK and the rest of the world
Trade in goods- deficit Trade in services - surplus Investment incomes (dividends, interest and remittance payments from abroad)- deficit Net transfers (international aid)- deficit
Explain the factors which influence demand for imports and exports
Price- imports into the UK have risen because low wage economies (China) can produce goods for less and charge lower prices
Exchange rate- a stronger pound will make imports cheaper and exports more expensive
Income- if incomes fall during a recession spending on imported goods will fall
State of the world economy- recession in trading partners could lead to a fall in domestic exports
Degree of protectionism- a high degree of protectionism leads to less imports, due to tariffs and quotas, and a increased difficulty to export.
Define Aggregate demand
Is the total amount of goods and services demanded in the economy at a given price in a given time period
Define the formula for aggregate demand
= Consumption + investment + government spending + exports - imports
Draw a aggregate demand graph
X
State the factors which effect aggregate demand
Consumption
Investment
Government spending
Exports and Imports
Define the marginal propensity to consume
The proportion of each £1 injected into the economy that is spent
Give the formula for the multiplier effect
1/1-MPC
Explain the effects of the combination of both the multiplier effect and the accelerator theory
What is its effect on aggregate demand
Can lead to increases in RGDP and therefore cycles of continuous growth, and further accelerator theory and multiplier effect cycles.
Can lead to further increases in aggregate demand
Give the formula for the marginal propensity to consume (mpc)
Change in consumption / change in income that caused change
Give the formula for the marginal propensity to save (mps)
Change in saving / change in income that caused change
Give the formula for the marginal propensity to import (mpm)
Change in imports / change in income that caused change
Give the formula for the marginal propensity to withdraw (mpw)
Change in withdrawals / change in income that caused change
Define aggregate supply
Is the quantity of goods and services that producers in an economy are willing and able to supply at a given level of prices
Define short run aggregate supply (SRAS)
What does it represent
Is the relationship between planned national output and the general price level, where money rates are fixed
Shows how much output the economy can generate in the short term at each price level
Draw a short run aggregate supply graph
X
State and explain the factors that cause shifts in the SRAS curve (acronym)
Wage rates- increased wages lead to higher costs and a shift in the SRAS curve
Exchange rates- a fall in exchange rates means the price of imported goods will rise and the prices will rise in the economy
Taxation- increase in tax will lead to increased costs and prices
Productivity- reduced productivity leads to increased costs
PINTSWC factors
Raw material prices- increased prices lead to increased costs and then increased prices
Define supply side shocks
Are factors which cause the short run aggregate supply to shift
Define the Long run aggregate supply (LRAS)
Refers to the maximum productive output an economy can produce when using all factors of production, whilst being sustainable
Draw a LRAS curve
X
What does the LRAS curve represent
What is its relationship with the SRAS
Represents the level of full capacity output of the economy, with no under-utilised resources and production at it’s long run maximum.
In the short run an economy may operare beyond its full capacity, however this is unsustainable and the output must fall back, in the long run output of the economy remains at its maximum, sustainably
Explain the importance of Quality and Quantity improvements in causing shifts in the LRAS curve
Quality and quantity improvements in factors of production can increase productive capacity and increase the LRAS curve
State and explain the factors that cause shifts in the LRAS curve (8)
Technological changes- improvements in technology will increase output and LRAS
Changes in productivity relative to competing economies- will lead to increased investment and then a increase in the LRAS
Changes in education - will improve productivity and LRAS
Changes in government regulations- favourable regulations can increase output in an economy
Migration- increased size of the workforce leads to increased output in the economy
Competition policy- increased competition in an economy encourages maximum efficiency and productivity
Factor mobility- leads to improved LRAS
State of the banking system - a strong banking system will make more funds available for firms to increase capacity
Draw and explain the effects of a reduction in taxes on a aggregate supply and demand graph
What does its effect depend on
Increased AD
Will reduce withdrawals in the economy. People will have more disposable income and therefore consumption increases, increasing aggregate demand.
It depends on the marginal propensity to consume
Draw and explain the effects of a increase in the costs of raw materials on a aggregate supply and demand graph
Decreased SRAS
Will increase costs of production and therefore reduce supply
Define and explain why stagflation occurs
Is a period of rising inflation but falling output and rising unemployment
Occurs due to supply side shock and falling productivity
Explain the effects of aggregate demand and why they will not always cause major changes in the economy, use increased tax as an example
What does the effects of changes effecting aggregate demand depend on
For any change in aggregate demand, it does not automatically lead to a major change in the economy. An increase in taxes will lead to a potential reduction in AD but will not cause a recession, as there are other factors in the economy that will increase aggregate demand. Increased taxes may lead to disinflation, where there is a reduction in the increase in the rate of inflation.
Depends on: the state of the economy on the cycle, the extent of the change which causes shift in the AD
Draw and explain the effects of a increase in investment on a aggregate supply and demand graph
Increase in AD, Increase in LRAS and SRAS
Results in an injection into the economy, increasing aggregate demand. Further increases in AD can occur from the multiplier effect. An increase in investment also adds to the productive stock of the economy, increasing LRAS and SRAS. Successful investment can lead to long run economic growth.
Define the negative output gap
Why does it occur
Occurs where there is a negative difference between the actual output being less than what the economy could produce at full capacity.
Occurs due to weak demand or a lack of efficiency
Define the positive output gap
Why does it occur
Occurs when actual output is more than full capacity output, this is not sustainable in the short run and eventually returns back to the equilibrium.
Occurs due to high demand and workers operating above their most efficient capacity.
Explain and draw the Keynesian model
Is a model which believes that optimal economic performance and the prevention of a recession can be achieved by government spending.
Explain how a Keynesian model work in the economy
At low levels of RGDP (unemployment is assumed to be high)it is easy for firms to find workers, to increase output
As LRAS get’s closer to the maximum output level for RGDP, it becomes more difficult to employ without there being a upward pressure on wages and prices, inflationary pressure
Eventually the Keynesian curve becomes perfectly inelastic as the full employment level of RGDP is reached, the economy is at full capacity.
State the objectives of AD/AS analysis
Measure economic growth
Measure employment
Inflation
