E - 10) How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts Flashcards
What is national income?
The monetary value of the flow of output produced in an economy over a period of time. National income can be measured as any point as income flows around the economy so national income = national expenditure = national output
What role do households have in the CFoI?
Own the productive resources of the nation, which they exchange for rent, wages, interest and profit with firms. They use the income earnt to buy goods and services from firms
What role do firms have in the CFoI?
Hire the resources as inputs to use them to produce output. They sell the goods and services produced, to households
What effects do different sectors have on the CFoI?
- Financial sector: not all income is spent, any saved is lent to businesses to invest
- Government sector: some income is taken out of the flow as tax, but they also spend which injects income into the CFoI
- Foreign sector: some income flows out to other countries when imports are purchased, exports add to the CFoI because income comes in from outside the economy
What are the injections and withdrawals of the CFoI and what do they cause?
Injections:
- Investment (I)
- Government spending (G)
- Exports (X)
- They add money to the flow, which leads to economic growth
Withdrawals:
- Savings (S)
- Taxation (T)
- Imports (M)
- They remove money from the flow, which leads to economic contraction
What are the different balances of national income equilibrium and what do they cause?
- Planned injections = planned withdrawals: national income equilibrium
- If injections exceed withdrawals: national income rises (economic growth)
- If withdrawals exceed injections: national income falls (economic contraction)
What is wealth with examples?
(Stock concept) – the value of assets held
Examples: income saved, value of shares, value of property owned, money held in pension funds
Wealth is more unevenely distributed than income
What is income with examples?
The flow of money going to factors of production
Examples: wages, salaries, rent, profits, people receiving benefits, interest paid
Income is less unevenely distributed than income
What is the aggregate demand (AD) curve and its formula?
Shows the relationship between the level of real planned expenditure and the genral price level in an economy
AD = C + I + G + (X - M)
What are the types of movements along the AD curve?
- Extensions - movement to the right (falls in general price level cause higher real GDP
- Contractions - movement to the left (rises in general price level cause lower real GDP
Why do AD curves have inverse relationships?
- Real income effect: as price level falls, the real value of income rises - consumers can buy more - higher consumption
- Balance of trade effect: falls in the relative price of level of a country could make foreign-produced goods more expensive - rise in exports and fall in imports
- Interest rate effect: if price inflation is low, interest rates might be reduced - less incentive to save - consumption rises. Exchange rate could also depreciate and improve net exports
What factors shift AD curves?
- Changes in real income and employment: job security - disposable income and confidence - investment
- Changes in consumer and buiness confidence - economic news, market sentiment, policy changes
- Changes in household wealth: asset and share prices - feel wealthier - confidence - loans
- Changes in monetary policy: interest rates -> attractiveness of saving and spending | mortagate interest payments fall - disposable income | borrowing costs and return on retained profit - investment
- Changes in fiscal policy: governemnt spending and public investment| income tax and VAT - disposable income and consumer confidence | corporation tax - firm investment
- Changes in exchange rate and the global economy: depreciation - reduces export prices and increases import prices (and vice versa)| global growth - net exports
What are characteristics of consumption in terms of AD?
Consumer spending on real output
Examples: non-durables, durables and services
Largest component of AD - about 60%
What are characteristics of investment in terms of AD?
Spending on capital goods that help
produce more consumer goods in future
Examples: plant, equipmen
Investment demand comes from
both private and public sector
What are characteristics of government spending in terms of AD?
Spending by the government on its current day-to-day provision of public services
Examples: healthcare, education, defence, transport
Does not include transfer payments (pensions and welfare benefits)
What are characteristics of net exports in terms of AD?
Exports are inflows of demand from citizens abroad
Imports are outflows of demand for foreign-produced goods
What factors affect consumption?
- Income: (especially real disposable income) consumer spending
- Wealth effect: value of assets - consumer spending
- Consumer confidence: consumer spending
- Job security: worry and confidence - spending
- Interest rates: cost of borrowing - spending on big ticket items
- Demography: population size (e.g. immigration) - amount of spending
What are benefits and drawbacks of rising consumption?
Benefits:
- Rising AD
- Faster short run economic growth
- Less spare capacity
- Falling unemployment
- Gives businesses confidence to
invest
Drawbacks:
- Inflation pressure
- Current account deficit (more imports sucked in)
- Unbalanced growth
- More household debt
- Bad for the environment
What is the fotmula for savings ratio?
Savings ratio = total household savings ÷ total household disposable income
Why is saving money important for economies?
- Savings flow into financial markets and businesses can access these funds to invest
- Savings provide households with a cushion of financial stability and funds for the government when it needs to borrow
