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 at any point because 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 movement along the AD curve?
- 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
Why does the AD curve have an inverse relationship?
- Real income effect
- Balance of trade effect
- Interest rate effect
What factors shift the AD curve?
Changes in:
- Real income and employment
- Consumer and buiness confidence
- Household wealth
- Monetary policy
- Fiscal policy
- Exchange rate and the global economy
What are characteristics of consumption in terms of AD?
- Consumer spending on real output
- Examples: non-durables, durables, 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, equipment
- 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
- Wealth effect
- Consumer confidence
- Job security
- Interest rates
- Demography
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
What is the Keynesian paradox of thrift?
Economic theory which states that an increase in saving can lead to a decrease in economic activity and a decrease in overall saving
What is the formula for average propensity to consume?
APC = consumption ÷ national income
What is the formula for marginal propensity to consume?
MPC = ∆ consumption ÷ ∆ national income
What is the formula for average propensity to save?
APS = saving ÷ national income
What is the formula for marginal propensity to save?
MPS = ∆ saving ÷ ∆ national income
What is investment with examples?
- Addition to capital stock of the economy
- Examples: factories, machines, offices, equipment, stocks of materials used to produce other goods
What is depreciation in terms of capital consumption?
Value of the capital stock that falls in value over time as it wears out or is used up
What is gross and net investment?
- Gross: investment before depreciation
- Net: gross investment minus depreciation
What is private and public sector investment with examples?
- Private sector: investment undertaken by businesses in the private sector
- Public sector: investment by the government often in infrastructure. Examples: transport, telecommunications, energy networks, new schools, new hospitals
What is foreign direct investment (FDI):
Capital investment made by companies based in one country, into another country
Why do firms invest?
- 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
How does investment impact AD and AS?
- AD: adds to AD - short-run growth - lower
unemployment - AS: adds to economy’s capacity - LRAS - long-run non-inflationary growth
What factors affect investment?
- Interest rate
- Availability of finance
- Demand for the final product
- Business confidence
- Corporate taxes
- Business regulation
- Technological change
How does investment affect the macroeconomy?
- 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
What is government spending?
- 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
What is central and local governemnt?
- Central: run at Westminster
- Local: local and county councils and city mayors
What is the role of governemnt spending?
- 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
What is budget deficit, surplus and balanced budget?
- 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
What is cyclical government spending?
- 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
What is trade surplus, deficit and trade balance equilibrium and their effect on AD?
- 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
What factors affect net trade?
- Real income
- Exchange rate
- State of global economy
- Degree of protectionism
- Non-price competitiveness
- Price competitiveness
What is the multiplier effect?
Occurs when an initial injection into the CFoI causes a bigger final increase in real national income
Why does the multiplier effect happen with an example?
- 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
What is the negative multiplier effect?
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
What is the formula for the multiplier coefficient?
Multiplier coefficient = final ∆ real GDP ÷ initial ∆ AD
What is the formula for the multiplier?
Multiplier (k) = 1 ÷ (1-MPC)
What is the formula for the multiplier in different economy situations?
- 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
What factors affect the size of the multiplier?
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
What is are investment, fiscal and export multipliers?
- Investment: initial change from investment
- Fiscal: initial change from governemnet spending or borrowing
- Export: initial change from exports
…On real national income (GDP)
Drawbacks of the multiplier?
- 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
What is short run aggregate supply (SRAS)?
Total planned output when the general price level can change, but the prices and productivity of factor inputs are held constant
What are the types of movement along the AD curve?
- 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
What factors shift the SRAS curve?
Changes in any costs of production
What is long run aggregate supply (LRAS)?
Total planned output when both price and average wage rate can change - measure of a country’s potential (maximum) output
What factors shift the LRAS curve?
- Change in the quantity of factors of production
- Change in the quality of factors of production
- Technological progress
What is the Keynesian AS curve?
- 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
How do shifts work on the Keynesian AS curve?
- 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
