How the Macroeconomy Works, Circular Flow of Income, AD/AS Analysis and Related Concepts Flashcards
what does national income measure
the total value of the goods and services a country produces yearly
can be measured by GDP, GNP and GNI
what is the circular flow of income
a model of the economy that shows how money is distributed around it
shown here:
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what is aggregate demand
the total demand in an economy
what is the downward slope of the AD curve explained by
Higher prices lead to a fall in the value of real incomes, so goods and services
become less affordable in real terms
(when the GPL is high on the AD curve)
If there was high inflation in the UK so that the average price level was high,
foreign goods would seem relatively cheaper. Therefore, there would be
more imports, so the deficit on the current account might increase, and AD
would fall.
(when the GPL is high on the AD curve)
High inflation generally means the interest rates will be higher. This will
discourage spending, since saving becomes more attractive and borrowing
becomes expensive.
(when the GPL is high on the AD curve)
what equation determines shifts in the AD curve
AD = C + I + G + ( X - M)
an increase or decrease in any of these factors will shift the AD curve left or right
what does the SRAS curve show
shows the quantity of real GDP which is supplied at different price levels in an economy
the AS curve is upward sloping because at a higher price level, producers are willing to supply more because they can earn more profits
Only changes in the price level, which occur due to changes in AD, lead to
movements along the AS curve.
what are conditions that shift the SRAS curve
The cost of employment might change, e.g. wages, taxes, labour
productivity
The cost of other inputs e.g. raw materials, commodity prices, the
exchange rate if products are imported
Government regulation or intervention, such as environmental laws
and taxes, and business regulation. Business regulation is sometimes
called ‘red tape’.
There could be a net outward migration of workers, which causes a
‘brain drain’ on the domestic economy, as skilled workers move
elsewhere.
difference between the SRAS and the LRAS
The short run aggregate supply curve (SRAS) only covers the period
immediately after a change in the price level. It shows the planned output of
an economy when prices change, whilst the cost of production and
productivity of the factor inputs are kept constant
The curve is upward sloping because supply is assumed to be responsive to a
change in AD, which is reflected in the price level.
The long run aggregate supply curve (LRAS) shows the potential supply of an
economy in the long run. This is when prices, and the costs and productivity
of factor inputs, can change. Similarly to the PPF, it can show the economy’s
productive potential.
The curve is vertical, because supply is assumed not to change as the price
level changes.
A right-ward shift in the LRAS curve shows economic growth
what determines a macroeconomic equilibrium
The economy reaches a state of equilibrium when the rate of withdrawals = the rate
of injections. This is equivalent to the point where AD = AS
what makes up the consumer spending portion of AD
Disposable income - income left after taxes for consumers
marginal propensity to consume - how much a consumer is willing to spend after a change in their income
a consumers marginal propensity to save - the proportion of each additional pound of household income that is used for saving
what influences consumer spending
changes in interest rates - lower interest rates -> increased spending as little incentive to save
higher interest rates -> incentive to save
consumer confidence -> confident about the state of the economy so therefore spend more
If consumers fear unemployment or higher taxes, consumers may feel less
confident about the economy, so they are likely to spend less and save more.
what influences investment (a segment of AD)
the rate of economic growth -> firms making more revenue from higher consumer spending -> more money to reinvest
business confidence - if business expect a high rate of return -> they will invest more
demand for exports -> increased demand -> more likely that the firm will reinvest as higher sales are expected
interest rates
investment increases as interest rates fall -> means the cost of borrowing is less and the return to lending is higher
the higher the interest rates -> the greater the opportunity cost of not saving the money
moreover -> the higher interest rate -> might make firms expect a fall in consumer spending -> likely to discourage investment
The rate of corporation tax could affect investment. Lower taxes means firms
keep more profits, which could encourage investment.
what is the business cycle
refers to the stage of economic growth that the economy is in
the economy goes through periods of booms and busts
Boom, recession, slump, recovery, boom and repeat
what is an economic boom
when economic growth is fast, and it could be inflationary or
unsustainable.
what is an economic recession
negative growth for 2 consecutive quarters
During recessions, there real output in the economy falls, and there is negative
economic growth
During recessions, governments might increase spending to try and stimulate the
economy. This could involve spending on welfare payments to help people who have
lost their jobs, or cutting taxes
during periods of economic growth…
During periods of economic growth, governments may receive more tax revenue since consumers will be spending more and earning more.
Government may decide to spend
less, since the economy does not need stimulating, and fewer people will be
claiming benefits.
during recessions…
During recessions, governments might increase spending to try and stimulate the
economy.
This could involve spending on welfare payments to help people who have
lost their jobs, or cutting taxes.
what is fiscal policy
Governments use fiscal policy to influence the economy. It involves changing
government spending and taxation.
Governments might spend on public goods and merit goods, as well as
welfare payments
Fiscal policy is a demand-side policy, so it works by influencing the level or
composition of AD.
what are automatic stabilisers
fiscal policies which offset fluctuations in the economy.
These include transfer payments and taxes. They are triggered without
government intervention.
how and why might government use expansionary fiscal policy during periods of decline
involves increasing spending on transfer payments or
on boosting AD, or by reducing taxes.
to boost the economy out of an e.g. recession in the economic cycle
how and why might government use contractionary fiscal policy during periods of growth
by decreasing expenditure on purchases and transfer payments.
Additionally, tax rates might increase. This reduces the size of the
government budget deficit.
discourages massive inflation
what is the (X - M) part of AD
exports - imports
A positive value indicates a surplus, whilst a negative value indicates a
deficit. The UK has a relatively large trade deficit, which reduces the value of AD. This
is the second largest component of AD.
the main influences of the trade balances:
real income:
During periods of economic growth, when consumers have higher incomes
and they can afford to consume more, there is a larger deficit on the current
account.
Exchange rates
A depreciation of the pound means imports are more expensive, and exports
are cheaper, so the current account trade deficit narrows.
state of the world economy:
A decline in economic growth in one of the UK’s export markets means there
will be a fall in exports. This is because consumer spending in those
economies will fall, due to falling real incomes.
Degree of protectionism:
Protectionism is the act of guarding a country’s industries from foreign
competition. It can take the form of tariffs, quotas, regulation or embargoes.
Non-price factors:
The competitiveness of a country’s goods and services, which is influenced
by supply-side policies, impacts how many exports the country has.
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what is the multiplier process
when there is new demand in an economy. This leads to
an injection of more income into the circular flow of income, which leads to
economic growth. This leads to more jobs being created, higher average incomes,
more spending, and eventually, more income is created.
can be shown on a diagram with multiple AD shifts
what is the multiplier ratio
the ratio of the rise in national income to the initial rise in AD
i.e. the number of times a rise in national income is larger than the rise
in the initial injection of AD, which led to the rise in national income.
calculation used with the MPC to calculate the multiplier
1
/
1 - MPC
why is it assumed that the LRAS curve is vertical
This view suggests that output is fixed at each level. All factors of production in the
economy are fully employed in the long run.
This means that changing AD, such as from AD1 to AD2, only makes a change in the
price level (P1 to P2), and it will not change national output (real GDP).
The position of the vertical LRAS curve represents the normal capacity level of
output of the economy.
what factors influence the LRAS curve
The LRAS curve is influenced by changes which affect the quantity or quality of the
factors of production. This is equivalent to shifting the PPF curve
Technological advances -> increased productivity or quality of production
changes in relative productivity -> more productive labour and capital input will produce a larger quantity of output with the same quantity of input
changes in education and skills -> improves the quality of human capital -> more productive and able to produce a higher quantity of output with the same quantity of input
changes in government regulations -> could limit how productive and efficient a firm is allowed to be -> ‘red tape’
demographic changes and migration -> if there is net inward migration and the majority of the population is of working age -> the size of the labour force is going to be significant
competition policy -> more competitive market encourages firms to be more efficient and more productive -> so they are not competed out of business -> can be used to stimulate the economy
what does the Keynesian view suggest about the LRAS curve
The Keynesian view suggests that the price level in the economy is fixed until
resources are fully employed.
The horizontal section shows the output and price
level when resources are not fully employed; there is spare capacity in the economy.
The vertical section is when resources are fully employed.
what are the characteristics of a boom
High rates of economic growth
Near full capacity or positive output gaps
(Near) full employment
Demand-pull inflation
Consumers and firms have a lot of confidence, which leads to high rates of investment
Government budgets improve, due to higher tax revenues and less spending on
welfare payments
what are the characteristics of a recession
In the UK, a recession is defined as negative economic growth over two consecutive
quarters.
The characteristics are:
Negative economic growth
Lots of spare capacity and negative output gaps
Demand-deficient unemployment
Low inflation rates
Government budgets worsen due to more spending on welfare payments and lower
tax revenues
Less confidence amongst consumers and firms, which leads to less spending and
investment
