CH9:Circular Flow of Income and Monetary Policy

Question 1

In MACROeconomics, what is the economy made up of?

Answer 1

P - Production - what is made and bought

I-Income (aka the money supply)

C-Consumption - what is consumed

Question 2

In the circular flow of money diagram - how is the size of the economy measured?

Answer 2

Measure day the total amount spent ie. Aggregate demand (total demand)

Question 3

What are examples of withdrawals?

Answer 3

Taxation
Savings
Imports

Question 4

What are examples of injections?

Answer 4

Borrowing (to invest)
Government spending
Exports

Question 5

How does inflation affect savings?

Answer 5

When inflation rates are greater than interest rates, people are disincentivised to save, as the real value of their money will fall

Question 6

Definition: tax relief

Answer 6

taxes which have already been paid are reimbursed

Question 7

Definition: Investment

Answer 7

the purchase of an item in the hope it will generate income or accrue value

Question 8

How do new or replacement investments affect investments?

Answer 8

Replacement investment is spending on replacing items. There is an increase in investment when net investment is positive :

Net investment = New investment - replacement investment

(ie. how much are actually new investments, new investments tend to grow the economy whilst replacement investments tend to keep things at the current level)

Question 9

Definition: National income

Answer 9

The total amount of goods and services produced over the course of a year, which is equal to the total amount earned by all people and businesses

Question 10

How do governments use Monetary policy to manage the economy?

Answer 10

• *Changing interest rates - key element of monetary policy

- Making borrowing and lending easier or harder

Question 11

What are consequences of increased interest rates?

Answer 11

1. Decreased investments - borrowing is more expensive and so decreases
2. Attraction of foreign funds - foreign investors move their funds to take advantage of interest rates (“hot money”)
3. Effects on the exchange rate - An inflow of foreign funds increases demand for that currency, leading to an increased exchange rate
4. Decreased inflation rates - high interest rates will encourage people to save vs. spend, reducing the pressure on prices
5. Decrease in asset value - assets which depend on the interest paid for their value (corporate or government bonds) may fall in value. ie. the existing bonds will not be as attractive as new bonds which are issued with higher interest rates vs. the old bonds.
6. Affect on sales - sales may fall as people choose to save more and borrow less
   * Decreased interest rates will have the opposite effect

Question 12

Definition: balance of payments

Answer 12

Looks at the value imports and exports and the difference between them

Question 13

What is the balance of payments made up of?

Answer 13

3 accounts:

1. Current account
2. Capital account
3. Financial account

Question 14

What is included in the CURRENT ACCOUNT?

Answer 14

Monies from:

Visible trade: trade in goods

Invisible trade: Trade in services, overseas income eg. salaries earned overseas or dividends paid out.
transfer of money to friends, foreign aid.

Question 15

What is included in the CAPITAL ACCOUNT?

Answer 15

Monies from buying/selling fixed assets (capital) eg. purchasing machinery

Question 16

What is included in the FINANCIAL ACCOUNT?

Answer 16

Monies from:

• Overseas investments eg. buying shares in an overseas company, or setting up a manufacturing facility overseas
• Reserve assets
• A balancing item

Question 17

Definition: reserve assets

Answer 17

There are assets held by the government in reserve eg. gold or foreign currency

Question 18

What is the balancing item?

Answer 18

The balance of payments is set up so that the sum of all 3 accounts is 0 by using a balancing item:

Current Ac + Capital Ac + Financial Ac + Balancing item = 0

Question 19

What is a surplus in the balance of payments?

Answer 19

An INJECTION into the economy

Question 20

What is a deficit in the balance of payments

Answer 20

A WITHDRAWAL from the economy)

Question 21

What determines the balance of the CURRENT ACCOUNT?

Answer 21

the level of IMPORTS/EXPORTS

Question 22

What is the main area of concern regards to the balance of payments?

Answer 22

if the CURRENT ACCOUNT is constantly in deficit

ie. imports > exports

Question 23

Definition: import penetration

Answer 23

the extent to which Imports are increasing

Question 24

Definition: export performance

Answer 24

the extent to which exports are being sold

Question 25

What are 3 ways governments may manage the balance of payments?

Answer 25

Do nothing - if the FX rate is allowed to move freely it is thought that it will naturally move to correct any imbalances

Actively affect FX rates - govs can buy/sell currencies to make exchange rates more favourable

Trade barriers - Govs can reduce import through high tariffs and quotas on imported goods

Question 26

How is MONETARY POLICY used to manage BALANCE OF PAYMENTS?

Answer 26

• Change interest rates
• Making borrowing/lending easier or harder
• Buying and selling currencies to change FX rates
• Imposing or removing trade barriers to make foreign trade easier or harder

Question 27

What are the most important measures of Money?

Answer 27

M0- notes and coins in use and amounts within accounts held at the central bank, eg. the US Federal Reserve (Narrow money in UK)

M4 - notes and coins within circulations and all private sector bank accounts (referred to as broad money in the UK)

Question 28

What is the effect on interest rates when there is low money supply?

Answer 28

The government may reduce spending, leading to reduced money supply. Less money in circulation means banks can INCREASE interest rates.

Question 29

What is the effect on interest rates when there is high money supply?

Answer 29

The government may increase spending, leading to increased money supply. More money in circulation means banks may have to DECREASE interest rates.

Question 30

Definition: Consumption

Answer 30

The amount of goods and services demanded in the economy

Question 31

What is the main factor affecting consumption and what is the measure of this called?

Answer 31

-Income level - as income increases, consumption increases.

Measure - Marginal propensity to consume (MPC)

Question 32

Formula: Marginal Propensity to Consume (MPC)

Answer 32

MPC = Change in Consumption / Change in Income

*the MPC will generally rise as income rises

Question 33

What other factors affect consumption?

Answer 33

Previous income - some people will continue to consume at the same level as previously even if their income increases

Future income - some people will increase their consumption if they think their income will increase in the future

Windfall gain or losses - people may react differently to receiving/losing money differently eg. some spend, some save

Government policy - governments can use monetary policy or taxation/public spending to encourage spending or saving

Wealth - the wealthier an individual the higher their level of consumption is likely to be

Question 34

Definition: Wealth

Answer 34

the market value of all assets less any amounts owed

Question 35

If the government imposes a restrictive fiscal policy (ie. increase VAT and income Tax), what would be the monetary policy to match this?

Answer 35

overall, the monetary policy to match a restrictive fiscal policy would be to limit /reduce the amount of credit circulating in the economy via:

• Halt all ongoing quantitive easing programs
• Gov buy bonds (at a higher interest rate) to raise interest rates hence reducing customer’s propensity to borrow from banks
• Sell treasury bills to reduce bank liquidity ie. its ability to lend

Question 36

What factors impact investments?

Answer 36

Business confidence

Interest rates

Expected future returns

Government policy

New or replacement investment

Question 37

What factors impact savings?

Answer 37

Income

Job security

Availability of credit

Contractual saving - eg. pension schemes

Tax relief - if levels of tax relief on products such as pensions increase, people are more likely to save

Inflation - less likely to save if inflation is high