Chapter 19 - The circular flow of income and aggregate demand Flashcards
What is the circular flow of income?
A model of the economy that shows the movement of goods and services between households and firms and their corresponding payments in money terms, together with the supply of factors of production.
How does the circular flow of income work?
• Households supply factor services to firms, in the form of labour, land, capital and enterprise. This is represented by the red arrow in
Figure 19.1.
• There is a corresponding flow of factor incomes from firms to households, including wages, salaries, rents, interest and profits.
• The output of goods and services produced by firms flows from firms to households in the form of consumer goods.
• Balancing the flow of output is a flow of expenditure, as households pay for the goods they obtain from firms.
What is meant by a leakage?
Where money flows out of the circular flow in the form of savings, taxation and imports.
What is meant by injections?
Where money flows into the circular flow in the form of investment, government spending and exports.
What are the injections into the circular flow?
- Government expenditure
- Exports
- Investment by firms
What are the leakages from the circular flow?
- Taxes raised by the government from households
- Spending on imports from the rest is the world.
- Household savings
How is balance in the overall economy achieved?
The overall economy will be in balance when planned injections are equal to planned leakages. Notice that there are connections between the injections and leakages - for example, household savings may enter financial markets, and firms borrow from financial markets in order to finance their investment expenditure.
International trade also affects the circular flow. Part of the expenditure on goods and services in the economy comes from abroad in the form of exports. In addition, part of the expenditure undertaken by households is on imported goods and services.
Notice that investment in the form of expenditure by firms on machinery, buildings and other productive resources plays an important role within the macroeconomy. By undertaking investment expenditure, firms add to the productive capacity of the economy, and so enable economic growth to take place. A change in the balance between investment and consumption activity therefore affects the long-run path of the economy.
An increase in expenditure on investment by firms may have other effects as well. In order to meet the additional demand for machinery, other firms need to expand production. This means that they need to hire extra workers — and pay them, of course. The additional workers will then spend part of their income on consumer goods, so unleashing a second round of expenditure.
What is gross domestic product (GDP)?
The total level of economic activity carried out in an economy during a given period.
What are the main components of aggregate demand?
- Consumption
- Investment by firms
- Government expenditure
- net exports (exports - imports)
What is the equation for AD?
AD = C + I + G + (X-M)
What is consumption?
The use of goods and services to satisfy wants - in the circular flow this is represented by consumer expenditure.
What is disposable income?
The income that households have to devote to consumption and saving, taking into account payments of direct taxes and transfer payments
What are the influences on consumption?
- As real incomes rises, household will tend to spend more
- However, they will not spend all of an increase in income but would save some of it.
Income will not be the only influence on consumption. Consumption may also depend partly on the wealth of a household. Notice that income and wealth are not the same. Income accrues during a period as a reward for the supply of factor services, such as labour. Wealth, on the other hand, represents the stock of accumulated past savings. If you like, wealth can be thought of in terms of the asset holdings of households. If households experience an increase in the value of their asset holdings, this may influence their spending decisions.
What are some theories about consumer expenditure?
Writers argued that consumption does not necessarily depend upon current income alone. For example, Milton Friedman put forward the “permanent income hypothesis”, which suggested that consumers take decisions about expenditure based on a notion of their permanent, or normal, income levels - that is, the income that they expect to receive over a 5- or 10-year time horizon. This suggests that households do not necessarily vary their consumption patterns in response to changes in income that they perceive to be only transitory.
An associated theory is the Life Cycle Hypothesis, developed by Franco Modigliani, who suggested that households smooth their expenditure over their lifetimes, on the basis of their expected lifetime incomes. So, people tend to borrow in their youth against future income, then in middle age, when earning more strongly, they pay off their debts and save in preparation to fund their expenditure in retirement. Consumer expenditure therefore varies by much less than income, and is based on expected lifetime earnings rather than on current income.
What is rate of interest?
The cost of borrowing and the reward for lending.
What is the consumption function?
The relationship between consumer expenditure and disposable income - its position depends upon the factors that affect how much households spend on consumer expenditure.
What does investment mean, in the circular flow?
Expenditure undertaken by firms to add to the capital stock.
Why does rate of interest influence investment spending?
The rate of interest is also likely to be influential in affecting firms’ decisions about investment spending. Again, this is because the interest rate represents the cost of borrowing. So, if firms need to borrow in order to undertake investment, they may be discouraged from spending on investment goods when the rate of interest is relatively high.
Investment leads to an increase in the productive capacity of the economy, by increasing the stock of capital available for production. This capital stock comprises plant and machinery, vehicles and other transport equipment, and buildings, including new dwellings, which provide a supply of housing services over a long period.
Although important, the rate of interest is not likely to be the only factor that determines how much investment firms choose to undertake. First, not all investment has to be funded from borrowing - firms may be able to use past profits for this purpose. However, if firms choose to do this, they face an opportunity cost. In other words, profits can be used to buy financial assets that will provide a rate of return dependent on the rate of interest. The rate of interest is therefore still important, as it represents the opportunity cost of an investment project.
In considering an investment project, firms will need to form expectations about the future stream of earnings that will flow from the investment. Their expectations about the future state of the economy (and of the demand for their products) will therefore be an important influence on current investment. This is one reason why it is argued that inflation is damaging for an economy, as a high rate of inflation increases uncertainty about the future and may dampen firms’ expectations about future demand, thereby discouraging investment.
Why are expectations important in expenditure?
Both consumption and investment expenditures are affected by the expectations formed by households and firms respectively. This influences the state of aggregate demand. If economic agents have pessimistic (opposite of optimistic) views about the future course of the economy, this can result in aggregate demand being lower than it otherwise would have been. Households may decide that they need to save more (and therefore spend less) to provide security for the future. Firms may decide not to undertake investment if they do not expect demand to be buoyant in the future.
How does net exports affect expenditure?
There are the factors that may influence the level of exports and imports. Most imports into the UK are normal goods, so as real incomes rise over time, there will be an increase in demand for imported goods. However, the demand for exports will depend upon changes in income in the UK’s trade partners. If there is slow economic growth in the countries that are customers for the UK’s exports, then this will have an impact on aggregate demand in the UK. The global recession that set in during the late 2000s had a noticeable effect on world trade.
Another factor that will affect both exports and imports is the exchange rate between sterling and other currencies. This affects the relative prices of UK goods and those produced overseas. Other things being equal, an increase in the sterling exchange rate makes UK exports less competitive and imports into the UK more competitive.
However, the demand for exports and imports will also depend upon the relative prices of goods produced in the UK and the rest of the world. If UK inflation is high relative to elsewhere, this will tend to make UK exports less competitive and imports more competitive. In 2018, a trade war threatened, with President Trump raising tariffs against some imports from China, later also extended to EU countries. This brought retaliatory action from China and the EU. The tariffs on goods from China were doubled again in May 2019, bringing retaliation in kind from China.
The demand for imports into the UK will depend partly upon the level of domestic aggregate income, and the demand for UK exports will depend partly upon the level of incomes in the rest of the world. Therefore, a recession in the EU will affect the demand for UK exports.
What does the aggregate demand curve show?
When the overall level of prices is relatively low, the purchasing power of income is relatively high. In other words, low overall prices can be thought of as indicating relatively high real income. Furthermore, when prices are low, this raises the real value of households’ wealth. For example, suppose a household holds a financial asset such as a bond with a fixed money value of £100. The relative (real) value of that asset is higher when the overall price level is relatively low. From the above discussion, this suggests that, ceteris paribus, a low overall price level means relatively high consumption. Conversely, an increase in the average price level reduces purchasing power, so reducing the quantity of real output demanded: this is the wealth effect.
A second argument relates to interest rates. When prices are relatively high, people are more likely to need to borrow in order to finance their spending, which will drive up interest rates, which in turn will discourage consumption and investment and therefore lead to lower aggregate demand.
A third argument concerns exports and imports. It has been argued that, ceteris paribus, when UK prices are relatively low compared with the rest of the world, this will increase the competitiveness of UK goods, leading to an increase in foreign demand for UK exports, and a fall in the demand for imports into the UK as people switch to buying UK goods and services.
All of these arguments support the idea that the aggregate demand curve should be downward sloping. In other words, when the overall price level is relatively low, aggregate demand will be relatively high, and when prices are relatively high, aggregate demand will be relatively low.
What is the wealth effect?
An effect by which an increase in the average price level reduces purchasing power and therefore the quantity of real output demanded
