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A-Levels > E - 10) How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts > Flashcards

E - 10) How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts Flashcards

1
Q

What is national income?

A

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 because income flows around the economy, so national income = national expenditure = national output

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2
Q

What role do households have in the CFoI?

A

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

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3
Q

What role do firms have in the CFoI?

A

Hire the resources as inputs to use them to produce output. They sell the goods and services produced, to households

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4
Q

What effects do different sectors have on the CFoI?

A
  • 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
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5
Q

What are the injections and withdrawals of the CFoI and what do they cause?

A

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
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6
Q

What are the different balances of national income equilibrium and what do they cause?

A
  • 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)
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7
Q

What is wealth with examples?

A

(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

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8
Q

What is income with examples?

A

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

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9
Q

What is the aggregate demand (AD) curve and its formula?

A

Shows the relationship between the level of real planned expenditure and the genral price level in an economy
AD = C + I + G + (X - M)

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10
Q

What are the types of movement along the AD curve?

A
  • Extensions - movement to the right - fall in general price level causes higher real GDP
  • Contractions - movement to the left - rise in general price level causes lower real GDP
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11
Q

Why does the AD curve have an inverse relationship?

A
  • Real income effect: as price level falls, the real value of income rises so consumers can buy more causing higher consumption
  • Balance of trade effect: falls in the relative price of level of a country could make foreign-produced goods more expensive causing rise in exports and fall in imports
  • Interest rate effect: if price inflation is low, interest rates might be reduced so there is less incentive to save causing consumption to rise. Exchange rates could also depreciate which improves net exports
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12
Q

What factors shift the AD curve?

A
  • 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
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13
Q

What are characteristics of consumption in terms of AD?

A

Consumer spending on real output
Examples: non-durables, durables, services
Largest component of AD - about 60%

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14
Q

What are characteristics of investment in terms of AD?

A

Spending on capital goods that help produce more consumer goods in future
Examples: plant, equipment
Investment demand comes from both private and public sector

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15
Q

What are characteristics of government spending in terms of AD?

A

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)

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16
Q

What are characteristics of net exports in terms of AD?

A

Exports are inflows of demand from citizens abroad
Imports are outflows of demand for foreign-produced goods

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17
Q

What factors affect consumption?

A
  • 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
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18
Q

What are benefits and drawbacks of rising consumption?

A

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
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19
Q

What is the fotmula for savings ratio?

A

Savings ratio = total household savings ÷ total household disposable income

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20
Q

Why is saving money important for economies?

A
  • 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
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21
Q

What is the Keynesian paradox of thrift?

A

Economic theory which states that an increase in saving can lead to a decrease in economic activity and a decrease in overall saving

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22
Q

What is the formula for average propensity to consume?

A

APC = consumption ÷ national income

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23
Q

What is the formula for marginal propensity to consume?

A

MPC = ∆ in consumption ÷ ∆ in national income

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24
Q

What is the formula for average propensity to save?

A

APS = saving ÷ national income

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25
Q

What is the formula for marginal propensity to save?

A

MPS = ∆ in saving ÷ ∆ in national income

26
Q

What is investment with examples?

A

Addition to capital stock of the economy
Examples: factories, machines, offices, equipment, stocks of materials used to produce other goods

27
Q

What is depreciation in terms of capital consumption?

A

Value of the capital stock that falls in value over time as it wears out or is used up

28
Q

What is gross and net investment?

A
  • Gross: investment before depreciation
  • Net: gross investment minus depreciation
29
Q

What is private and public sector investment with examples?

A
  • Private sector: investment undertaken by businesses in the private sector
  • Public sectort: investment by the government often in infrastructure. Examples: transport, telecommunications, energy networks, new schools, new hospitals
30
Q

What is foreign direct investment (FDI):

A

Capital investment made by companies based in one country, into another country

31
Q

Why do firms invest?

A
  • Expand their business and increase their output capacity
  • Reduce average costs of production due to economies of scale
  • Increase efficiency and productivity through innovation and technological progress
  • Meet an increase in market demand and increase market share
  • Expand firm’s product range
  • Replace depreciated capital
  • Increase competitiveness at home and abroad
32
Q

How does investment impact AD and AS?

A
  • AD: adds to AD - short-run growth - lower
    unemployment
  • AS: adds to economy’s capacity - LRAS - long-run non-inflationary growth
33
Q

What factors affect investment?

A
  • Interest rate: cost of borrowing - attractiveness of investing relative to retaining profit
  • Availability of finance: easieness to borrow
  • Demand for the final product: (accelerator process) incentive to expand to meet demand - profit potential
  • Business confidence: likeliness to invest
  • Corporate taxes: amount of retained profit for investment
  • Business regulation: red tape and bureucracy - incentive to invest
  • Technological change: fear of lagging behind competitors - invest in new technologies / innovations
34
Q

How does investment affect the macroeconomy?

A
  • Creates extra demand in investment goods industries
  • Injects money into the circular flow of income (multiplier effect)
  • Boosts both short-run and long-run economic growth
  • New capital boosts productivity and increases the capacity to supply
  • Improves a country’s competitiveness, improving the trade balance
  • Improves an economy’s infrastructure to make it more efficient
  • Can help create new jobs (though some may be lost to automation/AI)
  • Can help reduce inflation pressure
35
Q

What is government spending?

A

Day-to-day running costs of government
Examples: wages to public sector workers, energy and rent bills for government offices schools and hospitals
Also known as current spending by the government
Does not include transfer payments like government spending on welfare benefits or pensions

36
Q

What is central and local governemnt?

A
  • Central: run at Westminster
  • Local: local and county councils and city mayors
37
Q

What is the role of governemnt spending?

A
  • Change the level of AD (with fiscal multiplier)
  • Provide public and merit goods
  • Correct market failures like positive consumption externalities
  • Influence economic regions like ‘levelling up’
  • Achieve greater equity in society by providing public services, including universal access to healthcare and education
38
Q

What is budget deficit, surplus and balanced budget?

A
  • Deficit: government spending exceeds tax revenue - government borrows to fund its spending
  • Surplus: government spending is less than tax revenue - government can pay back some of its debt
  • Balanced budget: government spending equals tax revenue
39
Q

What is a fiscal multiplier?

A

Estimates the final change in real national income (GDP) that results from an initial change in government spending plans

40
Q

What is cyclical government spending?

A

When in an economic downturn/recession, government spending increases on welfare-benefits and support for businesses. The opposite occurs in a growth phase. The government can also choose to make discretionary changes to its spending, unrelated to the economic cycle like in the Budget

41
Q

What is trade surplus, deficit and trade balance equilibrium and their effect on AD?

A
  • Surplus: net export demand is positive - adds to AD
  • Deficit: net export demand is negative - reduces AD
  • Trade balance equilibrium: net export demand is neutral - AD remains unchanged
42
Q

What factors affect net trade?

A
  • Real income: amount of imports purchased
  • Exchange rate: depreciation - imports more expensive and exports cheaper (and vice versa)
  • State of global economy: global growth - demand for exports
  • Degree of protectionism: level of tarrif and non-tarrif barriers to trade
  • Non-price competitiveness: quality, design, speed of delivery, after-sales service
  • Price competitiveness: better value for money product
43
Q

What is the multiplier effect?

A

Occurs when an initial injection into the CFoI causes a bigger final increase in real national income

44
Q

Why does the multiplier effect happen with an example?

A

Because one agent’s spending is another agent’s income
Example: when a spending project creates new jobs, this creates extra injections of income and demand into the CFoI

45
Q

What is the negative multiplier effect?

A

Occurs when an initial withdrawal or leakage of spending from the CFoI, leads to knock-on effects and a bigger final drop in real GDP

46
Q

What is the formula for the multiplier coefficient?

A

Multiplier coefficient = final ∆ in real GDP ÷ initial ∆ in AD

47
Q

What is the formula for the multiplier?

A

Multiplier (k) = 1 ÷ (1-MPC)

48
Q

What is the formula for final change in real GDP?

A

Final ∆ in real GDP = initial ∆ in injections × multiplier (k)

49
Q

What is the formula for the multiplier in different economy situations?

A
  • In a closed economy with no government: k = 1/MPS
  • In a closed economy with a government k = 1/(MPS+MPT)
  • In an open economy with a government k = 1/(MPS+MPT+MPM) or 1/MPW
50
Q

What factors affect the size of the multiplier?

A

High multiplier value:

  • Economy has plenty of spare capacity
  • Propensity to import and tax is low
  • High propensity to consume any extra income

Low multiplier value:

  • Economy is close to full capacity
  • Rising demand causes inflation
  • Higher inflation causes rising interest rates

Both:

  • Size of withdrawals from the CFoI
51
Q

What is an investment, fiscal and export multiplier?

A
  • Investment: initial change from investment
  • Fiscal: initial change from governemnet spending or borrowing
  • Export: initial change from exports
52
Q

Drawbacks of the multiplier?

A
  • Difficult to know exact size of multiplier - hard to measure
  • Takes time for multiplier process to feed through to real GDP – time lag
  • Economists disagree over its size
  • Long-run multiplier effect is likely higher for developing economies than for developed ones - infrastructure projects often have higher multiplier effects
53
Q

What is short run aggregate supply (SRAS)?

A

Total planned output when the general price level can change, but the prices and productivity of factor inputs are held constant

54
Q

What are the types of movement along the AD curve?

A
  • Extensions - movement to the right - fall in general price level brought about by a shift in AD, causes higher real GDP
  • Contractions - movement to the left - rise in general price level brought about by a shift in AD, cause cause lower real GDP
55
Q

What factors shift the SRAS curve?

A
  • Changes in wage costs: real wages - costs of production - willingness to supply
  • Changes in productivity: output per labour input - efficiency - amount that can be supplied
  • Changes in unit labour costs: wage levels relative to productivity growth - ULCs - prepared to supply
  • Changes in commodity, energy and raw material costs: production costs - SRAS
  • Changes in education and skills: skills and occupational mobility - productivity - costs of production - SRAS
  • Changes in indirect taxes and subsidies: costs of production - SRAS
  • Changes in the exchange rate: appreciation decreases import prices - if a country is a net importer of energy, raw materials and components - decreases costs for many businesses - SRAS shifts right (and vice versa)
  • Changes in regulation: (government) red tape and bureaucracy - costs - SRAS
56
Q

What is long run aggregate supply (LRAS)?

A

Total planned output when both price and average wage rate can change - measure of a country’s potential (maximum) output

57
Q

What factors shift the LRAS curve?

A
  • Change in the quantity of resources (factors of production)
  • Change in the quality of resources (factors of production)
  • Technological progress
58
Q

What is the Keynesian AS curve?

A
  • Below Y1: AS is very elastic - the economy has lots of spare capacity and any increase in AD can easily be met without inflation
  • Between Y1 and Yfe: AS becomes less elastic - less spare capacity - increase in AD can be met, but costs to businesses start to increase as firms compete for skilled labour and other scarcer resources - some inflation
  • For Yfe and above: AS is perfectly inelastic - no spare capacity - an increase in AD will cause inflation not growth
59
Q

How do shifts work on the Keynesian AS curve?

A
  • Shifts in AS (with no change in Yfe): costs of production in the economy (same as SRAS) - left side shifts, right side does not
  • Shifts in AS (where Yfe changes): productive potential of the economy (same as LRAS) - right side shifts, left side does not
60
Q

What is the difference between classical and Keynesian economists’ views?

A
  • Classical economists: believe in the self-adjusting nature of markets, where wages and prices are flexible and the economy naturally tends toward full employment. They argue that government intervention is often counterproductive
  • Keynesian economists: emphasise the role of aggregate demand and argue that markets may not always self-adjust efficiently, especially during recessions. They advocate for government intervention, such as fiscal policies, to manage demand and stabilise the economy
61
Q

What factors shift the AS curve in the long-run?

A

Factors that increase the economy’s productive potential or its full employment level of output. Same factors that shift the PPF curve to the right:

  • Technological advances
  • Changes in relative productivity
  • Changes in education and skills
  • Changes in government regulations
  • Demographic changes and migration
  • Competition policy

A-Levels (94 decks)

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