4.2.2 Macroeconomic theory Flashcards
What is the circular flow of income?
- Households supply factors of production to firms
- Firms supply income to households (income flow)
- Households supply expenditure to firms (expenditure flow)
- Firms supply output to households (output flow)
What are examples of withdrawals in an economy?
Taxes, savings, imports
What are examples of injections into an economy?
Exports, government spending, investment (in capital goods)
What is aggregate demand?
The total demand for goods and services in a country
What is consumption?
How much of AD does it make up?
The amount spent on goods and services by UK consumers, making up 2/3rds of AD
What is the importance of increased consumption?
- More revenue for businesses increases profit, meaning potentially more capital investment
- Increasing imports worsens the trade deficit
What impacts consumption?
Current GDP, interest rates, consumer confidence, housing market, availability of credit, taxes
What are the impacts of increased consumption?
- More importation, worsening the trade deficit
- Potential for demand-pull inflation
- Greater GDP, increasing consumption, resulting in an even larger increase in GDP through the multiplier effect
- More employment
How does nominal GDP impact consumption?
Greater GDP means more consumption
What is the marginal propensity to consume?
The extra consumption from additional income (falls as income rises)
Why do savings limit consumption?
APC + APS (AP to save) = 1
How do interest rates have an impact on consumption?
Commercial banks increasing interest rates lowers consumption as borrowing costs increase, so less is borrowed to spend, mortgage repayments increase decreasing discretionary income, and there is more incentive to save.
What is discretionary income?
The money you have left after tax and paying for essentials
How does consumer confidence impact consumption?
More security in work, and pay rises, means more consumption
How does the housing market have an impact on consumption?
If house prices increase, people perceive themselves to have greater wealth, and therefore more have confidence, increasing consumption.
How does the availability of credit impact consumption?
If it is easier to get credit at a cheap ‘cost’, consumption increases.
How do taxes have an impact on consumption?
- For direct taxes: if income tax increases, disposable income decreases, meaning less consumption
- For indirect taxes: higher VAT means less consumption as costs increase for consumers
What does investment usually refer to?
Physical capital investment by UK firms, involving spending on capital goods, such as machinery and factories, as well as including FDI, human capital investment, and research and development.
What are the importances of investment?
- As investment is part of AD, if there is more investment in the short run, demand for capital goods increases, creating jobs, increasing NI, and resulting in multiplier effects
- In the long run economy will have higher quantity/quality of capital goods, shifting PPF
- Increasing productivity, decreases average costs, lowering prices, increasing competitiveness against other countries
What are the determinants of investment?
- Interest rates, as the cost of borrowing impacts viability of investment, for example a higher interest rate increases incentive save, decreasing the rate of investment, as it will be less profitable
- Availability of funds and loans
- Government policies, such as subsidised capital investment, cutting corporation tax, or tax breaks for investment
- Relative cost of capital to their labour
What are the different types of government spending?
- Current spending - running the public sector
- Capital spending - spending on infrastructure
What are the determinants of government spending?
- Inflation and growth
- Willingness to borrow
- Size of budget deficit
What are the determinants of exports?
- Cost and availability of factors of production, such as the unemployment rate
- Productivity
- Exchange rate
What is the accelerator process?
- The level of investment in an economy is related to the change in GDP, with a higher rate of economic growth causing more investment
- If the rate of economic growth is slowing, but the economy is still growing, the level of investment might fall
- But the level of investment is more volatile than the rate of economic growth
What is the multiplier process?
The relationship between a change in AD and the resulting larger change in NI.
What does aggregate supply show?
The level of real national output that producers are willing and able to supply at different average price levels in a given time period
What are the assumptions made when discussing AS?
- Cost of production, levels of technology, and productivity are all fixed
- Firms aim to maximise profits
- Rising marginal costs of production are faced
- To get firms to produce more, the price level has to increase to cover the extra costs
What are the factors that shift the short run AS curve?
Price level and costs of production:
- Subsidies and indirect taxes (VAT, excise duty on tobacco/fuel)
- Exchange rate changes (changing import costs)
- Labour costs
- Raw material costs
- Productivity changes
- Supply-side shocks (one-off unexpected events that impact SRAS)
What does long run AS show?
The real output that can be supplied when the economy is operating on the PPF (productively efficient)
What are the determinants of long run AS?
Level of technology, productivity, enterprise, factor mobility, economic incentives, government capital spending, immigration, birth rate, direct taxes (income/corporation taxes), training/education
What is the Keynesian AS curve?
- The price level in an economy is fixed until resources are fully employed
- Horizontal section shows the output and price level when resources are not fully employed, when there is spare capacity in the economy
- Vertical section shows when resources are fully employed
How would an increase in VAT affect a macroeconomic graph?
SRAS shifts left
Contraction in AD
How would an increase in business confidence affect a macroeconomic graph?
LRAS shifts right
AD shifts right
How would a decrease in income tax affect a macroeconomic graph?
LRAS shifts right
AD shifts right
How would an increase in government spending on infrastructure affect a macroeconomic graph?
LRAS shifts right
Extension in AD
How would an increase in unemployment affect a macroeconomic graph?
AD shifts left
Contraction in SRAS
How would a decrease in labour costs affect a macroeconomic graph?
SRAS shifts right
Extension in AD
How would a decrease in corporation tax affect a macroeconomic graph?
LRAS shifts right
AD shifts right
How would a decrease in interest rates affect a macroeconomic graph?
AD shifts right
Extension in SRAS
How would an increase in consumer confidence affect a Keynesian macroeconomic graph?
AD shifts right
Extension in AS
How would an increase in unemployment affect a Keynesian macroeconomic graph?
AD shift left
Contraction in AS
How would an increase in VAT affect a Keynesian macroeconomic graph?
AS shift up increasing the PL with no change to the YFE
Extension in AD
How would an increase in training/education spending affect a Keynesian macroeconomic graph?
AD shifts right
AS shifts right
How would a decrease in interest rates affect a Keynesian macroeconomic graph?
AD shifts right
Extension in AS
How would an increase in spending on public sector wages affect a Keynesian macroeconomic graph?
AD shifts right
Extension in AS
What does national income measure?
The flow of new output produced by an economy in a period, measured by the flow of factor of production incomes
What is the difference between nominal and real income?
- Nominal - current
- Real - adjusted for inflation
What is real national income an indicator of?
Economic performance
How are income, output and expenditure related in the circular flow?
Income = output = expenditure
What is full employment income?
The total output of an economy when unemployment is minimised or at the government target, accounting for frictional unemployment.
What is equilibrium in the circular flow of income?
- Where households spend all income and then firms pay it back to them
- Rate of withdrawals = rate of injections
What is the effect of net injections into the economy on national income?
Expansion of national output
What is the effect of net withdrawals into the economy on national income?
Contraction of production, so output decreases
What curves represent changes in the price level?
Aggregate demand (AD) and aggregate supply (AS)
What factors shift the AD curve?
Consumption, investment, government spending, imports, exports
How will an increase in consumption shift the AD curve?
Increase in AD
How will an increase in investment shift the AD curve?
Increase in AD
How will an increase in government spending shift the AD curve?
Increase in AD
How will an increase in imports shift the AD curve?
Decrease in AD
How will an increase in exports shift the AD curve?
Increase in AD
What shift of what curve represents underlying economic growth?
Rightward shift in the long run AS curve
Where is macroeconomic equilibrium on an AD/AS diagram?
The point where AD and AS meet
How do demand-side shocks affect the macroeconomy?
If firms have less confidence or there is a recession, AD shifts left, causing price level and national output (real GDP) to fall
How do supply-side shocks affect the macroeconomy?
If the economy becomes more productive or if there is an increase in efficiency, AS shifts right, lowering price level and increasing national output
How is AD calculated?
AD = C + I + G + X - M
Why may an initial change in expenditure lead to a larger impact on local/national income?
Due to the multiplier process, the original change in aggregate expenditures is spent more than once, cycling repeatedly through the economy, having a larger impact than the original expenditure change
How is the marginal propensity to consume used to calculate the size of the multiplier?
Multiplier = 1/(1- MPC) = 1/(1- ΔC/ΔI)
What are the determinants of imports?
Tariffs increasing causes imports to decrease
What does the vertical LRAS curve represent?
The normal capacity level of output of the economy
What are the benefits of saving?
- Savings can be used to lend, so borrowing can increase, possibly increasing investment
- More savings now implies more spending in the future
What are the negatives of saving?
Savings are leakages, so there is less money being spent, decreasing real GDP
What is the purpose of the accelerator process?
If rate of growth accelerates, investment also goes up, to maintain the ratio, have more money to invest, and increase the productive capacity
