Circular Flow Of Income Flashcards
What are the 4 uses of households
- Land owners
- Labour
- Capital owners
- Entrepreneurs
What are the 4 factor payments / income that constitute Y (national income)
- Wages
- Rent
- Interest/dividends
- Profits
What happens to national income when withdrawals = injection?
NY stays constant at equilibrium
What happens when injections (J) is greater than withdrawals (w)
NY rises
What happens when withdrawal (w) is greater than injections (J)
NY falls
Draw the diagram for the circular flow of income
Refer to notability
What constitutes Withdrawals
Saving
Taxes
Imports
S, T, M
How does withdrawals lead to a decrease in national income/output/expenditure
Increase in withdrawals in the form of savings
-> households spend less of their income on domestically produced goods
-> firms produce less output
-> revenue decreases
-> less income to pay to factories outputs
-> lower output/income/expenditure
What do injections comprise of?
- Investment expenditure (I)
- government expenditure (G)
- export expenditure (X)
How does injections (I,G,X) cause an increase in national output/income/expenditure
Increase in injections (IGX)
- increase in expenditure
- firms hire more fop to produce more output
- more revenue generated
- revenue returns to FOP, generating more factor income and in turn spending
- National output/expenditure/income increases
What 3 conditions have to be met for equilibrium level of national income?
- Total spending by 4 sectors of economy equals total income earned by FOP
- ALL goods and services produced by firms is bought up by the different sectors of the economy (no accumulation or shortage of inventories)
- Withdrawal (w) = injection (J)
What is aggregate expenditure (equation)
AE = Cd + I + G + X
What is the equation for AD
AD = C + I + G + (X-M)
What is the relationship between the general price level and the level of real national output or income
Inverse
Why is the aggregate demand curve downwards sloping (3)
- Wealth effect
- Interest rate effect
- International substitution effect
What is the relationship between general price level and real national output
Inverse
Explain the wealth effect (7 steps)
- When GPL falls,
- Purchasing power of households increases
- Assuming unchanged nominal income
- Households will be better off as same income can be used to buy more goods and services
- This makes consumers wealthier,
- Which in turn encourages them to spend more
- This implies a larger quantity of goods and services are demanded
Explain the international substitution effect (7 steps)
- Domestic price level falls
- Foreign prices remain constant
- Domestically produced goods are cheaper relative to foreign substitutes
- Ceteris paribus, residents are likely to demand less foreign goods
- Fall in income expenditure
- Foreigners likely to purchase more of the country’s goods and services that are relatively cheaper
- Fall in GPL therefore results in higher quantity of domestically produced goods and services are being demanded
Explain the interest rate effect (6 steps)
- When GPL falls
- Households need less money to purchase a given quantity of goods and services
- Given a fixed supply of money
- A fall in demand for money would cause interest rates to fall (loans not needed as much)
- Encourages borrowing for consumption on interest sensitive items
- Quantity of goods and services for consumption increases
**point to note - GPL fall causes interest rates to fall
What causes the AD curve to shift?
Non-price determinants of AD (non GPL factors)
What does autonomous consumption refer to?
Refers to consumption that is independent of RNY, and dependent on non-income factors (such as consumer confidence, interest rate)
- you shift the AD curve to account for the factor
What does induced consumption refer to?
Consumption dependent on current level of real national income
- shift AD curve according to increase or decrease in x axis (RNY)
What are the determinants of autonomous consumer expenditure (6)
1) Economic outlook and consumer confidence
2) Interest rate and access to credit
3) Expectations of future prices
4) Distribution of income
5) Wealth
6) Personal income taxes
Explain how the distribution of income is an autonomous factor of consumer expenditure
- rich tend to spend less of an increase in income on consumption
- almost all income distributed to the poor would be spent on consumption
- Redistribution of income from rich to poor in the form of higher income taxes increases consumption expenditure
What are the factors of autonomous investment expenditure? (4)
- Interest rate and access to credit (Marginal efficiency of investment - interest rate is inversely related to investment)
- Business confidence and expectations
- Corporate tax rates
- Technology changes
What is the MEI, and how does it relate to CBA (2 different perspectives)
Marginal rate of investment - expected rate of return of an additional unit of investment
CBA:
If MEI greater than or equals to interest rate, investment will be undertaken
If MEI less than interest rate, investment will not be undertaken
Alternatively,
If interest rate is an r0, firms will undertake investments up to l0 (on the MEI curve) and stop there (any more would be unprofitable as MEI < r
How would a fall in interest rates change the MEI curve?
- fall in interest rates would increase investments
- downward movement along MEI curve
How does business confidence and expectations change the MEI curve
- If firms are more optimistic about economic activity
- firms expect the rate on investments to increase
- this causes a SHIFT in the MEI curve to the right
- assuming interest rates remain unchanged, parallel increase in quantity of investments from l1 to l2
How does corporate tax rates change the MEI curve?
- reduction of corporate tax rates causes the firm’s after tax profits to increase
- increases firms wilingness and ability to invest
- increase in investment expenditure - shift of MEI curve right
What are the determinants of net exports (X-M) - 4
- National income of trading partners/domestic households
- Changes in other countries’ general price levels
- Exchange rates
- Trade policies (protectionism vs free trade)
What are the determinants of net exports (X-M) - 4
- National income of trading partners/domestic households
- Changes in other countries’ general price levels
- Exchange rates
- Trade policies (protectionism vs free trade)
How does technology change affect the MEI curve
Development of technology causes MEI to shift to the right
- r stays the same, parallel increase in level of investment from I1 to i2
What are the determinants of government expenditure in the long run
- Government revenue
- national reserves
- access to credit
What is the assumption for the direct relationship between a trading partner’s national income rise and the export revenue of the exporting nation?
Normal goods are being exported
How does an increase in domestic households income affect net exports and aggregate demand
If country A’s national income rises, people have more purchasing power, demanding more imports, M rises, net exports fall
HOWEVER, even though net exports fall, increase in consumption of domestically produced goods results in aggregate demand to still increase
