Circular Flow Theory Flashcards
Macroeconomic theory
What does the circular flow theory illustrate?
It illustrates the movement of income and expenditure in an economy, showing the interdependence between households, firms, the government, and foreign sectors.
What role do households play in the circular flow model?
Households supply factors of production (land, labor, capital, and entrepreneurship) and receive income in return (wages, rent, interest, profit).
What is the role of firms in the circular flow model?
Firms produce goods and services using factors of production and pay households for these services.
What are the two main types of markets in the circular flow model?
- Goods Market: Where households spend income on goods and services produced by firms.
- Factor Market: Where firms purchase factor inputs from households.
What creates the “continuous flow” in the circular flow model?
Income earned by households is spent on goods/services, sustaining firms and creating a cycle of economic activity.
What are injections in the circular flow of income? Provide examples.
Injections are additions to the economy’s circular flow of income, increasing aggregate demand and national income. Examples include:
- Investment (I)
- Government Spending (G)
- Exports (X)
What are withdrawals (leakages) in the circular flow of income? Provide examples.
Withdrawals are reductions in the circular flow of income, decreasing aggregate demand. Examples include:
- Savings (S)
- Taxes (T)
- Imports (M)
What happens to national income if injections exceed withdrawals?
National income rises, causing an expansionary effect.
What happens to national income if withdrawals exceed injections?
National income falls, causing a contractionary effect
How do changes in injections and withdrawals affect aggregate demand (AD)?
- Increases in injections: Shift the AD curve outward, stimulating economic growth.
- Increases in withdrawals: Shift the AD curve inward, leading to lower economic activity
What is the multiplier effect?
It is the process by which an initial change in injections leads to a larger cumulative change in national income
What is the formula for the multiplier?
Multiplier = 1 / (1 - MPC), where MPC is the marginal propensity to consume
What happens in equilibrium national income?
Equilibrium occurs when planned injections equal planned withdrawals (I + G + X = S + T + M).
What occurs in disequilibrium when S > I?
National income falls due to net leakage.
What occurs in disequilibrium when I > S?
National income rises due to net injection.
What distinguishes the simple and extended circular flow models?
- Simple Model: Considers only households and firms, ignoring government and foreign trade.
- Extended Model: Includes government (taxes and spending) and international trade (imports and exports).
What is the purpose of the Phillips Machine?
To demonstrate the dynamics of income flow and macroeconomic policies using water flow to simulate economic variables.
What is the Keynesian perspective on deficient aggregate demand?
Deficient aggregate demand can lead to recessions due to imbalances between planned savings and investment, advocating for government intervention to stimulate demand.
How do Classical and Keynesian economists differ in their views on restoring economic equilibrium?
- Classical Economists: Believe in self-correcting mechanisms like falling interest rates with minimal government intervention.
- Keynesian Economists: Stress the need for fiscal and monetary policies to counteract deficient demand.
How does circular flow theory aid in policy formulation?
It helps design fiscal and monetary policies by understanding injections and withdrawals, such as using stimulus packages to increase injections during downturns.
What is the relationship between MPC and MPS?
MPC + MPS = 1, where MPC is the marginal propensity to consume, and MPS is the marginal propensity to save.
What is the difference between an open and a closed economy?
- Open Economy: Includes foreign trade (exports and imports).
- Closed Economy: Excludes foreign trade.
What are some strengths of the circular flow theory?
- Provides a clear framework for understanding macroeconomic relationships.
- Facilitates policy analysis and economic forecasting.
What are some limitations of the circular flow theory?
- Simplistic assumptions in basic models.
- Real-world complexities like behavioral factors and global interdependencies require more sophisticated models
