Ch.7 How The Macroeconomy Works

Question 1

What are the three ways that you can measure national income?

Answer 1

National income can be calculated by using the:
Expenditure method
Income method
Output method

Question 2

What is the expenditure method?

Answer 2

This involves adding up all the spending over a period of time by using
Consumption + investment + government expenditure + net exports.
This is signified by:
C + I +G + (X-M)

Question 3

What is consumption?

Answer 3

Spending by households on goods and services.

Question 4

What is investment?

Answer 4

Spending by businesses on additions to the capital stock, such as new premises or equipment, or the building up of inventory (stock) levels.

Question 5

What is government expenditure?

Answer 5

Spending by the government at both national and local levels within the economy.

Question 6

What are net exports?

Answer 6

The value of exports less the value of imports in an economy over a period of time.

Question 7

What is the income method?

Answer 7

Adding up all the incomes earned over a period of time:
Wages and salaries earned by those in work,
Rent by those who allow their land and property to be used by others,
Interest earned by those who invest capital in financial assets,
Profits earned by companies trading goods and services.

Question 8

What is the output method?

Answer 8

Totalling the value of all output produced in the economy for a period of time for each sector of the economy. Steps need to be made to avoid double counting, for example the output of the steel industry may be used in the production of cars and should only appear once.

In non-traded sectors (education ,NHS…) a value for their output is based on the cost of their provisions.

Question 9

What are the comparisons of the different methods?

Answer 9

The three methods shapely all give the same or incredibly close values as they all include the same transactions over a period of time, but each method views the transaction from a different angle.

National income = national expenditure = national output.

Question 10

What does real national income measure?

Answer 10

Real national income measures the national income after removing the effect of price changes from its value. This means that any increase in real income refers to any increase in output and does not merely represent higher prices charged for the same amount of production.

Question 11

How do you calculate real national income?

Answer 11

Real National Income = nominal national income multiplied by (the price level in the previous year divided by the price level in the current year).

Question 12

How do you calculate Economic growth for a year?

Answer 12

Economic growth is calculated by:

Subtracting the previous nominal national income from the real NI, then by dividing that by the previous nominal national income and multiplying that by 100. That will give you the economic growth for a certain year.

Question 13

What is the difference between GDP and real national income?

Answer 13

Real national income and GDP are not the same variable as some U.K. National income come from incomes earned outside of the uk but still belonging to U.K. Citizens.

Gross national income includes the incomes from overseas assets. However, the difference between GDP and GNI is small and these terms are often used interchangeably.

Question 14

What are the uses of real national income?

Answer 14

It is a measure of how successful the economy is - countries are often ranked in importance by the size of their national incomes.

It shows how well off the population is - through measuring the national income per person.

It allows a government to estimate how much can be collected in taxation ( most taxes are placed on income and expenditure- both measures of national income).

Question 15

What is the circular flow of income?

Answer 15

A model of the economy where income and spending flow between households and firms. This shows how money flows around the economy as a result of the transactions taking place.

Question 16

What happens in the circular flow of income?

Answer 16

In a simple two sector economy (consisting of just the business and the household sector), businesses employ factors of production supplied by households to produce goods and services.

In return, households supply their labour (and other factors) and earn incomes from firms, which households then spend as consumption on goods and services.

The level of national income will remain constant as money flows from households to businesses and back again; although this is not exactly how the uk economy behaves.

Question 17

What does a modified model of the circular flow of income include?

Answer 17

A modified model of the circular flow of income includes both injections (in the form of investment by businesses) and withdrawals (in the form of household savings).

Question 18

What are injections?

Answer 18

Extra money placed into the circular flow of income.

Question 19

What are withdrawals?

Answer 19

Money taken out of the circular flow of income.

Question 20

What happens when there is a lack of balance in the circular flow of income?

Answer 20

If injections are greater than withdrawals, more is being added to the circular flow and income overall will rise. If there is a greater quantity of withdraws than that of injections it means that there will be falling incomes.

Question 21

What is included in a more complex circular flow of income?

Answer 21

In a more complex model of the circular flow of income there are injections and withdrawals:

Injections:
Investment
Government expenditure
Exports

Withdrawals:
Savings
Taxation
Imports

Question 22

What are the requirements for macroeconomic equilibrium?

Answer 22

Macroeconomic equilibrium is reached in the circular flow of income model if there is no pressure on national income to rise or fall.

Question 23

What is macroeconomic equilibrium?

Answer 23

The level of national income where there is no tendency for the level to change. In the circular flow model the economy will remain in equilibrium as long as the total of planned injections is equal to the total of planned withdrawals. This can be stated as:
I + G + X = S + T + M

Question 24

What happens if total injection are greater than total withdrawals?

Answer 24

National income will increase until a new equilibrium level of national income is reached when injections are equal to withdrawals.

Question 25

What happens if withdrawals are greater than injections?

Answer 25

National income will fall until a new equilibrium is reached at a lower level of national income.

Question 26

What is aggregate demand?

Answer 26

Total planned spending in an economy over a period of time at any given price level. It is calculated as C+I+G+(X-M). This is another model for looking at macroeconomic equilibrium.

Question 27

What are key points about the AD curve?

Answer 27

The AD curve appears as downward sloping from left to right, this is because:

At a lower price level, value of any assets (property, shares…) will increase in real terms. This may lead to the wealth effect - making consumers feel as though they have greater wealth, leading to higher consumption rates.

A lower price level will make U.K. Exports more price competitive (compared to foreign substitutes), thus leading to a higher level of exports sold abroad. It will also make domestic goods relatively cheaper than imported goods, which should reduce the level of imports.

Question 28

What is the wealth effect?

Answer 28

Increases in the value of a household’s assets cause people to feel wealthier and encourage them to spend more of their current income (or to borrow more to finance their current spending).

Question 29

What is wealth?

Answer 29

Wealth refers to the value of the assets held by households. Most wealth will be held in the value of property (or equity) owned by the households.

Question 30

What causes changes in the levels of aggregate demand?

Answer 30

If one of the components (consumption, investment, government expenditure, exports and imports) changes then the level of aggregate demand may change.

Question 31

What are some of the factors influencing consumption?

Answer 31

Interest rates, consumer confidence, taxation, wealth and unemployment.

Question 32

What are interest rates?

Answer 32

The cost of borrowing money expressed as a percentage of the amount borrowed.

Question 33

How do interest ares affect consumption?

Answer 33

If interest rates rise, people that have loans or monthly mortgage repayment will find that prices increase and they have less money to spend on consumption.

Higher interest rates can reduce the desirability of households to engage in credit - financed consumption.

Higher interest rates increase the rewards for saving which reduces the level of consumption.

Question 34

Why will consumption rise and fall with consumer confidence?

Answer 34

If households are worried that they may lose their job then there is a much higher chance that they will save money and reduce the current consumption. If people are sure that they are going to keep their job it is the opposite.

Question 35

What is the effect of taxation on consumption?

Answer 35

If there is an increase in tax (especially income tax) it will reduce the amount of disposable income that households have, so they will decrease spending and consumption. If there is a reduced tax people will have a greater amount of disposable income and there will be an i cesse in disposable income.

Question 36

What is the effect of wealth on consumption?

Answer 36

If household wealth increases it may have a positive wealth effect on households, which means they will probably spend more in consumer goods and services.

Question 37

What is the effect of unemployment on consumption?

Answer 37

If more people are unemployed and relying on welfare benefits, then the level of consumption is likely to be lower.

Question 38

How do intérêt rates have an effect on investment?

Answer 38

Higher interest rates raise the cost of borrowing and will reduce the profitability of any investment project. Even if an investment project is not financed by borrowing, higher interest rates will raise the opportunity cost of using money for investment purposes.

Question 39

How does business confidence have an effect on investment?

Answer 39

If a business is confident that sales of a product will increase in the future they are more likely to invest in that product and increase their productive capacity to meet the demand in the future.

Question 40

How will tax have an effect on investment?

Answer 40

If taxes are lowered (such as corporation tax) companies will have more of their profits to spend (potentially on investment).

Question 41

How does technology have an effect on investment?

Answer 41

New technologies can increase productivity and so businesses will invest in new technology to increase their profitability.

New technology will also generate new markets for firms and will lead to firms investing more as a way of exploiting the new opportunities that technology brings.

Question 42

How will the accelerator theory have an effect on investment?

Answer 42

Increase and decreases in the rate of growth of national income will lead to even larger increase in the level of investment.

If growth in national income increases then firms will need a larger productive capacity to produce a higher level of output to meet the higher level of spending in the economy.

If the growth rate of national income falls, then firms will not need a large productive capacity and investment in maintaining capacity can fall.

Question 43

What is the accelerator theory?

Answer 43

Where increases in national income leads to firms spending more on investment, in order to expand their capacity to exploit the rising income.

Question 44

What areas in the economy will the government spend money on?

Answer 44

The areas in the economy that the government will spend money on are:
Public services (health, education, transport)
Local government services (libraries and other council services)
Welfare expenditure (pensions, care allowance, tax credits and benefits)
Interest on debts (payments on outstanding government debt accumulated over time).