Circular Flow of Income, AD/AS Analysis & Related Concepts Flashcards
Circular Flow of Income
- Firms & households interact & exchange resources in an economy
- Households supply firms with FOP (e.g labour, capital) & in return, receive wages & dividends
- Firms supply G&S to households
Injections: (GIX)
- Gov Spending
- Investment
- Exports
Withdrawals: (STI)
- Saving
- Taxes
- Imports
Effect of Injections & Withdrawals on National Income
- Economy reaches state of equilibrium when withdrawals = injections
- Amount of savings = amount of investment
- In UK, there is low savings rate, so rate of investment is also low
- If there are net injections into the economy, there will be an expansion of national output
- If there are net withdrawals from the economy, there will be a contraction of production, output decreases
Determinants of AD
- Consumption
- Investments
- Gov Spending
- Net Trade (X-M)
Factors Affecting of Consumption
- Disposable Income: Amount of income consumers have left over after taxes & social security charges have been removed, what consumers choose to spend
Marginal Propensity to Consume: How much consumer changes their spending following a change in income
Marginal Propensity to Save: Proportion of each additional pound of income that is used for saving
MPC + MPS = 1
-
Interest Rates: Lower interest rates, cheaper to borrow & reduces incentive to save, so spending & investment increase
Lower interest rates also lower cost of debt (e.g mortgages), increasing effective disposable income of households -
Consumer Confidence: Higher confidence levels, so invest & spend more, as they feel they will get a higher return
If consumers fear unemployment/higher taxes, less confident so spend less & save more
Delays large purchases (e.g houses, cars)
Factors Affecting of Investment
Investment: Accounts for 15-20% of GDP in UK, about ¾ from private sector
Influences on investment:
Economic Growth: If growth is high, more revenue, more profits available to invest
Business Expectations & Confidence: If high rate of return expected, firms invest more
- Firms need to be certain about the future, or postpone investments
- Also expectations about society & politics
Demand for Exports: Higher demand = more likely to invest
Interest Rates: As interest rates falls, cost of borrowing is lower
- Higher interest rates = greater opportunity cost of not saving money
Access to Credit: If banks & lenders unwilling to lend (e.g after financial crisis), harder to get credit
- Firms could use retained profits
- Availability of funds dependent on level of saving in the economy
Influence of Gov & Regulations: Rate of corp. tax could affect investment
- Lower taxes means firms keep more profits, could encourage investment
Accelerator Effect: Suggests level of investment in economy is related to change in GDP
- Higher rate of growth causes more investment
- If rate of growth is slowing, but the economy is still growing, level of investment might fall
- Level of investment more volatile than rate of growth
Factors Affecting of Gov Spending
Gov Spending: How much gov spends on state goods & services (e.g schools, NHS)
- Accounts for 18-20% of GDP
Trade Cycle: Stage of growth that economy is in
- Economy goes through periods of booms & busts.
- Output increases during growth
- During recessions, gov may increase spending to stimulate economy (e.g welfare)
Fiscal Policy: Used to influence economy, involves changing gov spending & taxation
- Fiscal policy = demand-side, influences AD
- Discretionary fiscal policy = implemented through one-off policy changes
- Automatic stabilisers = policies which offset fluctuations in economy
- Expansionary: During economic decline, increasing spending on transfer payments, boosting AD, or reducing taxes
- Contractionary: During economic growth, decrease expenditure on purchases & transfer payments, increase tax rates, reduces gov budget deficit
Factors Affecting of Net Trade
Real Income: During growth, consumers have higher incomes so consume more, larger deficit on current account
- During periods of decline, incomes fall, leads to improvements in UK current account
Exchange Rates: Depreciation= Imports more expensive, exports cheaper, so trade deficit falls
- Depreciations make currency more competitive against others
- However, depends on which currency (e.g not major trading partners)
- Demand for UK exports has to be price elastic to lead to increase in exports
State of World Economy: Decline in growth in one of UK’s export markets means fall in exports
- E.g Economic downturn in EU, demand for UK G&S will fall, as EU consumers less able to afford imports
Degree of Protectionism: Act of guarding country’s industries from foreign competition
- In the form of tariffs, quotas, regulation or embargoes
- Protectionist Measures = Reduced trade deficit, due to less importing
- However, protectionism leads to retaliation, exports might decrease too
Non-Price Factors: Competitiveness of a country’s G&S impacts amount of exports
- Become more competitive through innovation, higher quality, operating in niche market, lower labour costs, better infrastructure
- Trade deals, trading blocs, can open/close significant export opportunities
Multiplier Effect
Multiplier Effect: Occurs when there is new demand
- Leads to injection of more income into circular flow, which leads to economic growth
- This leads to more jobs created, higher average incomes, more spending, & eventually, more income is created
- Refers to how initial increase in AD leads to an even bigger increase in national income
- It occurs since ‘one person’s spending is another person’s income’
- Multiplier Ratio: Ratio of rise national income to the initial rise in AD
- No. of times a rise in national income is larger than the rise in initial injection of AD
Reverse Multiplier Effect
Reverse Multiplier: Withdrawal of income from circular flow could lead to even larger decrease in income for the economy
- Could decrease economic growth & potentially lead to decline in the economy
