Macro Topic 2- Circular flow of income & AD

Question 1

Explain how households and firms interact within the circular flow of income

Answer 1

• Households= provide factors of production to firms

Firms= Use these factors of production to produce goods & services

Question 2

Explain the 2nd stage of the circular flow of income-

i.e after firms have produced goods & services from the factors of production provided by households.

Answer 2

Households= receive factor incomes (e.g for labour= wages) as a reward for providing the FOP

• Households then use these factor incomes as consumer expenditure on goods & services produced via firms.

Question 3

Overall what does the circular flow of income model show?

Answer 3

The movement of spending and income throughout the economy.

Question 4

What is the misconception with regards to FACTOR INCOMES which we assume by the circular flow of income?

Answer 4

We assume that ALL factor incomes are going to be spent on g&s….

Not all income is spent in economy
- incomes= saved, taxed, import spending.

Question 5

What are the 3 leakages out of an economy?

Answer 5

1) savings- (s)
2) Taxation (T)
3) Imports (M)

Question 6

What is the misconception with regards to consumer expenditure which we assume by the circular flow of income?

Answer 6

That only CONSUMERS have expenditure on goods & services.

Could be other sources of expenditure in the economy

• Firms= Investment
• Govt= Government spending
• Exports= foreigners spend

Question 7

What are the 3 Injections into an economy?

Answer 7

Investment (I)= by firms
Government spending (G)
Exports (X)

Question 8

If injections are GREATER than leakages in an economy. (more money is entering the economy than leaving it)

What is the impact on economic growth?

Answer 8

Economic growth is going to be RISING

Question 9

If injections are LESS than leakages in an economy(more money leaving our economy than entering it)

What is the impact on economic growth?

Answer 9

Economic growth is going to be DECREASING

Question 10

If both the injections and leakages in an economy are EQUAL.

What is the impact on economic growth?

Answer 10

There will be no increase or decrease in economic growth

Macroeconomic equilibrium.

Question 11

What does national income measure?

Answer 11

It is a sum of all the goods and services than an economy produces in a given year.

Total amount of income flowing AROUND an economy.

Question 12

What is Nominal income?

Answer 12

This is the sum of all goods & services produced in that year at that year’s price.

Generally higher than in reality, because price levels may increase.

Question 13

What is real income?

Answer 13

This is the sum of all goods & services produced however it takes into account rises in price levels.

Question 14

What is real national income a measure of?

Answer 14

An economy’s performance over time, therefore it is an indicator of economic performance.

Question 15

List the 3 methods of calculating GDP.

Answer 15

Output method
Income method
Expenditure method

Question 16

What is the output method of calculating GDP?

Answer 16

Adding up the final sum of all G&S in an economy.

This is the output method of calculating GDP

Question 17

What is the income method of calculating GDP?

Answer 17

By adding up all factor incomes earned in an economy earned in a year.

Adding up all the

• wages & salaries
• profits
• Interests
• rent

Question 18

What is the expenditure method of calculating GDP?

Answer 18

Adding up consumer expenditure=

• investment
• government spending
• net exports

Question 19

what is the relationship between the output, income and expenditure method?

Answer 19

They all EQUAL each other and so it doesn’t matter which method is used.

output=income=expenditure

Question 20

Define Aggregate demand

Answer 20

This is the total demand in the economy and it measures total EXPENDITURE

Question 21

List the components of AD

Answer 21

Consumption
Investment
Government spending
Exports- imports= NET exports

Question 22

Why is the AD curve downward sloping?

Answer 22

This is because of reasons to do with the price level changing

Question 23

Explain what the wealth effect is and how it is related to the AD curve being downward sloping

Answer 23

• As price level decreases
• purchasing power of income increases
• so people= more richer
• more spending money on g&s
• consumption INCREASES, causing AD to increase, causing real GDP to increase(shifts right ).
• So extension in AD curve

Question 24

Explain what the trade effect is and how it is related to the AD curve being downward sloping

Answer 24

• As price level decreases
• Exports= more competitive, imports= less competitive
• demand for exports= increases, and imports demand decreases
• because demand for imports is decreased, M decreases
  so the value of (X-M) INCREASES, causing AD to increase, causing real GDP to increase (shifts right ).
• So extension in AD curve

Question 25

Explain what the interest effect is and how it is related to the AD curve being downward sloping

Answer 25

• As price level decreases
• Interest rates can be kept lower in economy
• means that consumption & investment increases & value of (x-m) increases, causing AD to increase, causing real GDP to increase (shifts right ).
• So extension in AD curve

Question 26

Why would the AD curve shift left or right?

Answer 26

Either an increase or decrease in 
consumption 
investment 
government spending 
net exports

Question 27

What is the distinct difference between the reasons for AD curve shifting and extending/ contracting?

Answer 27

AD curve will SHIFT not because of price level but because of its components increasing or decreasing.

AD curve slopes downwards because of the price level.