4.2.2 - How The Macroeconomy Works : The Circular Flow Of Income , Aggregate Demand/ Aggregate Supply Analysis And Related Concepts

Question 1

Define and explain the circular flow of income

Draw it in a diagram

Answer 1

Shows connections between different sectors of an economy, shows flows of goods and services and factors of production between firms and households.

Question 2

Explain Withdrawals in terms of the circular flow of income.

What do they include

Answer 2

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)

Question 3

Explain Injections in terms of the circular flow of income

What do they include

Answer 3

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)

Question 4

Define National output

Answer 4

Is the value of the flow of goods and services from firms to households

Question 5

Define National Expenditure

Answer 5

Is the value of spending by households on goods and services, from households to firms

Question 6

Define a closed economy

Define a open economy

Answer 6

Is an economy where there is no foreign trade

Is an economy where there is trade with other countries

Question 7

Explain the multiplier effect

Answer 7

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

Question 8

Define consumption

Answer 8

Is spending by households on goods and services

Question 9

State factors determining consumption (6)

Answer 9

Interest rates
Consumer confidence 
Taxation
Wealth
Inflation
Composition of households

Question 10

Explain Interest rates as a factor determining consumption

Answer 10

If interest rates rise it reduces the desire of households to engage in credit financed consumption and increases the incentive to save, reducing consumption

Question 11

Explain consumer confidence as a factor determining consumption

Answer 11

Households will have varying degrees of confidence about the future. If they feel that their incomes could fall they are likely to reduce consumption.

Question 12

Explain taxation as a factor determining consumption

Answer 12

Changes in taxation will effect how much households have to spend. Increased taxes will lead to reduced overall consumption

Question 13

Explain wealth as a factor determining consumption

Answer 13

If households wealth decreases, they will spend less on consumer goods and services

Question 14

Explain inflation as a factor determining consumption

Answer 14

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.

Question 15

Explain the Composition of households as a factor determining consumption

Answer 15

The more young and old the households the higher proportion of their incomes spent and therefore the greater consumption

Question 16

Define Investment

Answer 16

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

Question 17

Define Gross investment

Define Net investment

Answer 17

Measures investment before depreciation

Gross investment with the effects of depreciation

Question 18

Define Physical capital

Define Human capital

Answer 18

Is investment into physical things like factories

Is investment into the education and training of workers

Question 19

State the factors determining investment (8)

Answer 19

Interest rates
Rate of economic growth
Costs
Business expectations and confidence
World economy 
Access to credit
Retained profit
Influence of government regulation

Question 20

Explain interest rates as a factor determining investment

Explain the liquidity trap

Answer 20

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

Question 21

Explain the rate of economic growth as a factor determining investment

Explain the accelerator theory

Answer 21

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.

Question 22

Explain costs as a factor determining investment

Answer 22

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.

Question 23

Explain Business expectations and confidence as a factor determining investment

Answer 23

If a firm expects sales to fall and loses confidence, they are likely to cut back on their investment

Question 24

Explain the world economy as a factor determining investment

Answer 24

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

Question 25

Explain access to credit as a factor determining investment

Answer 25

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

Question 26

Explain retained profit as a factor determining investment

Answer 26

Most investment is financed from retained profits. If retained profits are low, firms will tend not to invest.

Question 27

Define Government spending

Answer 27

Includes all government consumption, investment and transfer payments

Question 28

Define current spending

Define capital spending

Answer 28

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

Question 29

Explain what the significance of government debt depends on

Answer 29

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

Question 30

Define Direct Taxes

Define Indirect taxes

Answer 30

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

Question 31

Define Progressive Taxes

Define Regressive Taxes

Answer 31

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

Question 32

Define a Fiscal Deficit

Define a Fiscal Surplus

Answer 32

Occurs where government spending is greater than taxation

Occurs where government spending is less than taxation

Question 33

Define the current account balance of payments

What does it consist of (deficit or surplus)

Answer 33

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

Question 34

Explain the factors which influence demand for imports and exports

Answer 34

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.

Question 35

Define Aggregate demand

Answer 35

Is the total amount of goods and services demanded in the economy at a given price in a given time period

Question 36

Define the formula for aggregate demand

Answer 36

= Consumption + investment + government spending + exports - imports

Question 37

Draw a aggregate demand graph

Answer 37

X

Question 38

State the factors which effect aggregate demand

Answer 38

Consumption
Investment
Government spending
Exports and Imports

Question 39

Define the marginal propensity to consume

Answer 39

The proportion of each £1 injected into the economy that is spent

Question 40

Give the formula for the multiplier effect

Answer 40

1/1-MPC

Question 41

Explain the effects of the combination of both the multiplier effect and the accelerator theory

What is its effect on aggregate demand

Answer 41

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

Question 42

Give the formula for the marginal propensity to consume (mpc)

Answer 42

Change in consumption / change in income that caused change

Question 43

Give the formula for the marginal propensity to save (mps)

Answer 43

Change in saving / change in income that caused change

Question 44

Give the formula for the marginal propensity to import (mpm)

Answer 44

Change in imports / change in income that caused change

Question 45

Give the formula for the marginal propensity to withdraw (mpw)

Answer 45

Change in withdrawals / change in income that caused change

Question 46

Define aggregate supply

Answer 46

Is the quantity of goods and services that producers in an economy are willing and able to supply at a given level of prices

Question 47

Define short run aggregate supply (SRAS)

What does it represent

Answer 47

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

Question 48

Draw a short run aggregate supply graph

Answer 48

X

Question 49

State and explain the factors that cause shifts in the SRAS curve (acronym)

Answer 49

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

Question 50

Define supply side shocks

Answer 50

Are factors which cause the short run aggregate supply to shift

Question 51

Define the Long run aggregate supply (LRAS)

Answer 51

Refers to the maximum productive output an economy can produce when using all factors of production, whilst being sustainable

Question 52

Draw a LRAS curve

Answer 52

X

Question 53

What does the LRAS curve represent

What is its relationship with the SRAS

Answer 53

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

Question 54

Explain the importance of Quality and Quantity improvements in causing shifts in the LRAS curve

Answer 54

Quality and quantity improvements in factors of production can increase productive capacity and increase the LRAS curve

Question 55

State and explain the factors that cause shifts in the LRAS curve (8)

Answer 55

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

Question 56

Draw and explain the effects of a reduction in taxes on a aggregate supply and demand graph

What does its effect depend on

Answer 56

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

Question 57

Draw and explain the effects of a increase in the costs of raw materials on a aggregate supply and demand graph

Answer 57

Decreased SRAS

Will increase costs of production and therefore reduce supply

Question 58

Define and explain why stagflation occurs

Answer 58

Is a period of rising inflation but falling output and rising unemployment

Occurs due to supply side shock and falling productivity

Question 59

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

Answer 59

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

Question 60

Draw and explain the effects of a increase in investment on a aggregate supply and demand graph

Answer 60

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.

Question 61

Define the negative output gap

Why does it occur

Answer 61

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

Question 62

Define the positive output gap

Why does it occur

Answer 62

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.

Question 63

Explain and draw the Keynesian model

Answer 63

Is a model which believes that optimal economic performance and the prevention of a recession can be achieved by government spending.

Question 64

Explain how a Keynesian model work in the economy

Answer 64

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.

Question 65

State the objectives of AD/AS analysis

Answer 65

Measure economic growth
Measure employment
Inflation