Chapter 7 - Income and wealth, aggregate demand, aggregate supply and equilibrium.

Question 1

National Income?

Answer 1

The amount received by various agents in an economy. The same as GDP. Assumes leakages (savings, tax, imports) and Injections (investments, government spending and exports) have been taken into account. Its a flow of money, rather than stocks or physical assets.

Question 2

Leakages?

Answer 2

Outflows from the circular flow of money. Comprising of: Savings Taxation Monet spent on imports

Question 3

Wealth?

Answer 3

The stock assets in an economy.

Question 4

Asset?

Answer 4

An accumulation of wealth. Factors which can be used to provide income in the future. AKA capital sock.

Question 5

What is the relationship between income and wealth?

Answer 5

There is a strong correlation. Ownership of wealth can be a direct contributor to income e.g. rent or interest payments. When asset prices fall, so too may confidence, having an impact on expenditure.

Question 6

What is the significance of assets?

Answer 6

Can be used as collateral/ security for a loan.

Question 7

What are the three Injections into the circular flow of income?

Answer 7

Investment - An increase in capital stock. Government Spending - NHS for instance. Exports - People abroad purchase domestically produced goods and services.

Question 8

The circular flow of income?

Answer 8

Represents the relationship between firms and households. Consumer expenditure is paid for by dividends, rent and wages.

Question 9

Investment?

Answer 9

An increase in spending when capital assets are bought as well as consumer items.

Question 10

Aggregate Demand?

Answer 10

The total amount of planned spending on goods and services at any price level in the economy.

Can be drawn as a straight line or curve. Shows that as the general price level falls, national income, output and expenditure will increase.

Question 11

Why is the Aggregate Demand Curve downward sloping?

Answer 11

The Real Balance Effect: A decrease in the price level increases the real value of money. The larger the quantity of real money, the larger the quantity of goods and services demanded.

The International Trade Effect: If UK goods become cheape, then ceterus paribus, UK citizens will buy more UK goods.

The Substitution Effect over time: A fall in the average price levelmeans there are lower interest rates. This means there is a shift in the aggregate demand from the future to the present, thereby increasing the number of goods demanded today.

Question 12

Aggregate Demand Formula?

Answer 12

AD = C + I + G + (X - M)

Question 13

Consumption with respect to aggregate demand?

Answer 13

The spending of households on goods and services, making the main component of AD (65%).

The main determinants of consumption are:

1. Interest Rates: If interest rates rise then it costs more for us to borrow. It therefore increases the oppertunity cost of spending (i.e. saving). Higher interest rates mean savers profit.
2. Consumer Confidence: Confident households, regarding jobs, future economy prospects etc increase the chance of consumers purchasing big ticket items such as cars. People views of the economy are therefore majorly what shape it.
3. Wealth Effects: An increase in the share price or house prices means that households will spend more. They can take out a larger loan to invest.
4. Level of employment and wage rates: high unemployment, higher expenditure, more employment.

Question 14

Wealth effect?

Answer 14

The effect on spending or incomes when asset prices change.

Question 15

Investment with respect to AD?

Answer 15

Defined as increase in the capital stock.

Interest Rates: High interest rates decreases investment.

Confidence Levels: Optimism for future profits sparks investment.

Risk: High Risk reduces investment.

Government Decisions: Changes in policy will effect investment (e.g. lower coorperation tax).

Government Bureacracy:Reduced red tape (e.g. planning restrictions) increases investment.

Question 16

Government Expenditure with respect to AD?

Answer 16

Governents have some degree of flexibility when it comes to spending.

In the short run, the government doesnt have to balance its books.

A Fiscal or budget deficit occurs when expenditure is greater than taxation, increasing the flow of income and therefore AD.

A Fiscal or budget surplus occurs when tax revenue exceeds expenditure, leading to a contraction of aggregate demand.

Question 17

What is Discretionary Fiscal Policy?

Answer 17

When the government manipulates total spending in the economy by changing their own level of spending.

Question 18

Net Exports with respect to AD?

Answer 18

In the UK this is a negative figure, meaning exports < imports.

Changes in the Exchage Rate: High exchange rate, uncompetitive pricing, exports fall. Liable to changes in the short run though due to time lags and elasticities.

Changes in the state of the world economy: The UK Exports over 60% of goods/ services to the EU countries. Heavy interdependence increases the risk of economic slowdown when the world economy is slowing down.

Non-price factors: Price dependent on quality, reliabily, service, transports costs etc…

Question 19

When is the a movement along the AD curve?

Answer 19

When there is a change in price level caused by factors unrelated to aggregate demand, e.g. AS.

Question 20

When is there a shift in the AD curve?

Answer 20

When any of the composites changes [c + i + g + (x - m)]

The size of this change depends on the multiplier effect.

Question 21

Show and state the effects of an increase in AD

Answer 21

If aggregate demand shifts rightward, there will be an increase in prices (inflation) and an increase in real output (economic growth)

Question 22

Show on an AD diagram the effects of a leftward shift of AD and state any observations.

Answer 22

If aggregate demand shifts leftward, there will be a decrease in prices (deflation) and a decrease in real output (economic slowdown or recession)

Question 23

Aggregate Supply?

Answer 23

The amount that various firms within an economy are willing to supply within a given price level.

Based on the costs of production and incorperates rent, wages, interest and profit.

As prices rise, firms are generally willing to supply more but there comes a point when forms reach maximum capacity whivh we will call full employment.

You can draw the AS curve as a straight line or sloping upwards to indicate that there are rising costs as firms try to produce more.

Or you can draw a courve starting horizontal ( to show there is spare capacity) and an upward sloping part where there are bottlenecks in the economy. The vertical part represents full employment.

Question 24

Explain some situations that would cause AS to shift Up/Left,

Answer 24

Oil price rises. Firms not willing to supply unless they can recieve more more money for the same output.

If invesment falls, for example if interest rates have risen, then aggregat supply will decrease.

If there is a shortage of certain factors of production. e.g. skilled labour, costs will rise for firms.

Question 25

Spare Capacity? What is the Keynesian View and Classical View?

Answer 25

When there are unemployed resources in an economy.

If the economy can increase output without significant costs (aggregate supply not vertical), then there is said to be spare capacity.

Keynesian economists believe there can be an equilibrium in an economy and also be spare capacity. Governemnts can take action to stimulate the equilibrium unemployment to achieve long-term growth and employment. The free hand not 100% efficient.

Classic Approach to aggregate supply suggest that there cannot be spare capacity and an equilibrium. Eventually the spare capacity will disappear. Therefore Aggregate Supply is vertical in the long-run. Wages will fall until people can find work.

Question 26

Show what hapens when there is a shift in aggregate supply.

Answer 26

Movements along the aggregate supply curve occur when aggregate demand shifts and the proce level changes.

If there is an increase in AD, AS will expand and firms will produce more.

If there is a decrease in AD, AS will contract and firms will produce less.

Question 27

Why does Aggregate Supply Shift?

Answer 27

Changing Costs of Raw materials

Changing Levels of International Trade

Changes in Exchange Rates

Technological Advances

Relative productivity changes

Education Skills changes

Regulation Changes

Changes in the Minimum Wage

Changes in the Tax and Benefit System

Question 28

What is Equilibrium and What are the obvious conclusion about prices around this point?

Answer 28

The balancing point where there is no tendency to change.

Prices above the Eq point would have a tendency to fall because supply would be greater than demand, resulting in unsold goods/ services.

If price was below Eqp then there would be shortages, resulting in the price increasing.

Question 29

What is the Multiplier Effect?

Answer 29

The multiplier shows the amount by which a change in an injection or leakage causes total spending to change. It is the result of income being re-spent in the economy, having second and successive round effects.

If there are injections into the economy, there will be a larger final change on total spending in the economy. The multiplier times the injection gives the final change to spending.

A postitive multiplier increases total expenditure in the economy.

Any leakages from the circular flow will reduce the effects of the multiplier.

Question 30

What are Second round effects wih respect to the multiplier?

Answer 30

Changes when firms, individuals and governments respond to initial changes.

Question 31

Why is the multiplier important?

Answer 31

The total effects on an economy will be much greater than the intiail injection or leakage. The multiplier therefore magnifies the impact of changes on the economy as a whole.