Macroeconomic theory

Question 1

Circular flow of income

Answer 1

This is an economic model showing the flow of goods and services, the factors of production and their payments between households and firms within the economy.

Question 2

A closed model

Answer 2

This means there are no foreign trade and no government finance, only two groups, households and firms.

Question 3

National Output

Answer 3

Firms produce goods and services. These goods are national output.

Question 4

National Income

Answer 4

The households in a country provide the labour, land and capital that firms use to produce the national output. The money paid to households by firms for these factors of production is the national income.

Question 5

National expenditure

Answer 5

Households send the money they get from the national income on the goods and services that firms creat, this value is national expenditure.

Question 6

Assumptions of the closed circular flow

Answer 6

1. Households spend all their income on goods and services.
2. Firms spend all their income on factors of production.
3. There is no government and there is no foreign trade.

Question 7

The Multiplier effect

Answer 7

This occurs when an initital injection into an economy, or circular flow of income causes a larger final increase in the level of real national income/output

Question 8

Net injections can either be positive or negative

Answer 8

If the injections are greater than the wtihdrawasls then this is a positive net injection, the final increase in GDP will be greater than the net injection.

If the injection is less than the withdrawls than this is a negative net injection, the final decrease in GDO will be greater than the next injection.

Question 9

Should the flows be equal?

Answer 9

YES, National Income = National output = National expenditure

Question 10

Why does the AD curve slope downwards?

Answer 10

1. The net exports effect, lower domestic prices mean that there is greater international price competiveness, this means that net exprots are high at a lower price, resulting a rise in aggregate demand and real GDP.
2. The real wealth effect, If price level falls than purchasing power increases and realth wealth rises, if people get wealthier than they spend more and GDP rises.
3. Interest rate effect, at higher prices interest rates are likely to be raised by the monetary authorities, higher interest rates will be shown to reduce several components of AD.

Question 11

Factors that effect consumption in the economy?

Answer 11

Income
confidence
Interest rates
Housing market, positive wealth effect and equity release
Saving
Income tax

Question 12

Factors that effect investment in the economy?

Answer 12

Future sales (rate of economic growth, expectations and confidence, government incentives, regulation)
Interst rates

Question 13

LRAS curve

Answer 13

This represents the maximum possible output an economy can produce as determined by its available land, labour, capital and entrepreneurial resources

Question 14

The shape of the Keynesian LRAS curve

Answer 14

• There is an assumption that in the LR money wage rates and all other factor inputs are sticky downwards. This means that wages may find it hard to fall, due to national minimum wages, trade union disputes and reluctance to do so by firms due to negative impacts on worker producitivty.
• At high level of output, the economy is operating at full capacity, the AS curve becomes verticle, just as with the classical model. No more output can be produced with the current factors of production in the economy. At output levels below this point the economy is operating below full capacity, unemployment however emerges, in the classical model, wages would fall to eliminate this unemployment. However in this model wages are sticky downwards and firms can fire workers.

Question 15

Shifts in the LRAS curve

Answer 15

• Increase in quality and quantitiy of FOP.
• Increasing in FOP productivity
• Changes in factor market flexibility and changes in technology.

Question 16

Why is the SRAS curve upwards sloping?

Answer 16

1. Sticky wages, nominal wages are slow to adjust to changes in the overall price level (i.e., they are sticky). That means when the price level falls, most firms cannot adjust wages immediately, which leads to an increase in real production costs. As a consequence, the suppliers hire fewer workers and produce a smaller quantity of goods and services.
2. The short-run aggregate supply curve slopes upward because the prices of some goods and services are slow to adjust to changes in the overall price level. That means when the overall price level falls, some firms may find it hard to adjust the prices of their products immediately. This causes sales to drop, which in turn leads to a decrease in the quantity of goods and services supplied. According to the sticky price theory, the primary reason for sticky prices is what we call menu costs. Menu costs describe all costs incurred by firms in order to change their prices

Question 17

SRAS Assumptions

Answer 17

• In the short run money wage rates and all other factor inouts are ficed.
• If firms want to rpoduce more in the short run they are unlikely to hire extra workers, instead the exisitng workforce will be asked to work harder (through overtime) resulting in increase pay and therefore higher prices. In the short run there is a positive relationship between price and realGDP.

Question 18

Movement along the SRAS curve

Answer 18

• A rise in rpice level leads to a extension on the curve and a fall in price level leads to a contraction.

Changes in AD lead to movements along the curve, if AD increase firms will hire more labour, make resources work harder in order to boost supply as they see a oppurtunity to boost profits whilst there is increased demand.

Question 19

Factors that shift SRAS

Answer 19

Labour
Commodities
Exchange rate
Taxation and subsidies

Question 20

Classical v Keynsian in the long run

Answer 20

• The classical view is that the economy will always produce the maximum output that FOP allow it to.
  They also believe that markets will always function efficiently in the lon run and so the economy will produce on the boundary of its PPF and thus the LRAS curve will be verticle.
• John Maynard Keynes however believed that an economy could be in equalibirum below full employment, he concluded that the LRAS curve was upwards sloping and did have a verticle section but at times the economy coudl settle at a level of output below full employment.

Question 21

Natural rate of unemployment

Answer 21

The NRU is the rate of unemployment when the labour market is in equalibrium. It corresponds to full employment, no matter where AD is, frictional and structural unemployment will always exist so even af fullemployment there is unemployment.

Question 22

How does the Classical LRAS curve adjust to a fall in AD?

Answer 22

In the long run money wage rates and all other factor input prices are fully variable, the economy always produces at the full capacity level of output. YFE, as wages will self adjust to ensure this.

A negative demand shock means that AD falls at all prices, this causes the economy to move to a SR equalibrium at an output below YFE. SRAS shift down because in the long run wages are driven down, reducing firms costs. At a given level of real GDP, the SRAS function is therefore lower. There is a new equalibrium established at a lower price.

Question 23

How does the Keynesian LRAS curve adjust to a fall in AD?

Answer 23

There is an assumption that in the LR money wage rates and all other factor inputs are sticky downwards. This means that wages may find it hard to fall, due to national minimum wages, trade union disputes and reluctance to do so by firms due to negative impacts on worker producitivty.
This means that the AD can shift along the LRAS curve at will, no adjustment will take place, it is possible we operate below YFE with a negative output gap. There is a view that governments will have to intervene in the form of monetary policy and expansionary fiscal policy to shift AD.

Question 24

Allocative efficiency

Answer 24

A more precise definition of allocative efficiency is at an output level where the Price equals the Marginal Cost (MC) of production.
This is because the price that consumers are willing to pay is equivalent to the marginal utility that they get.
Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.
The demand curve is marginal utility.

Marginal utility is greater than marginal cost until MC=AR, past this point the marginal cost is greater than the marginal utility/benefit.