Macroeconomic theory Flashcards
what is the circular flow of income? (simple) (4)
a basic model of the economy that shows:
- how households provide the 4 factors of production to firms
- firms make g&s out of the factors of production
-household receive factor incomes ( wages, rent, dividends)
- these incomes go towards consumer expenditure
who are the 3 economic agents?
-banks
- government
- abroad
- what is a withdrawal?
- give 3 examples
- ways that incomes leak out of the circular flow of income ( money leaves the economy )
- savings (s)
taxation (t)
imports (m)
- what are injections?
- give 3 examples
- money which goes into the economy outside of consumer expenditure
- investment (i)
government spending (g)
exports ( x )
how can we know if the economy is growing? (2)
- if injections are greater than leakages -there is more money entering the economy than leaving the economy
how can we know if the economy is shrinking?
- if withdrawals are greater than injections
- more money is leaving the economy than entering it
- so the economy will shrink
what is macroeconomic equilibrium?
- if injections and withdrawals are equal so there is a balance
what is GDP
- the measure of economic growth ( gross domestic product )
why do we use GDP
- to precisely measure economic growth
what are the 3 methods of measuring GDP?
- Output method - looking at the final value of all goods and services produced in an economy in a year
- Income method - Adding up all the factor incomes earned in an economy in a year
- total expenditure - C + I + G + ( X - M )
what can be said about the 3 methods of GDP
- they are equal
- output = income = expenditure
- the three are going to be equal to one another regardless of the method used
what is the multiplier effect?
the increase in final income arising from any new injection of spending
explain the multiplier effect
- any increase in spending by AD going up will create income for somebody else
- this will facilitate the spending by those people
- creating income for somebody else
- and so on
how do we calculate the multiplier?
(3)
- multiplier (k) = change in real GDP (y) / change in injections (j)
- 1/ 1- (marginal propensity to spend)
- 1/ (marginal propensity to withdraw)
what can determine the value of the multiplier? (3)
the marginal propensity to consume
- the bigger the mpc the bigger the multiplier
- the smaller the mpc the smaller the multiplier
what determines the marginal propensity to consume?
- a culture of saving in the economy
- if there’s lots of tax
- marginal propensity to spend on imports
these will reduce the multiplier value
- what is the accelerator effect?
- explain the accelerator effect
(4)
- changes in investment can be directly linked to changes in the rate of GDP growth
- -when the rate of gdp growth is increasing, firms are more willing to invest
- this is because they think that demand is going to be high in the future
- so now’s a good time to invest momey into capital
- slow down is opposite
- this is because they think that demand is going to be high in the future
what is aggregate demand (AD) ?
(2)
- the total demand for goods and services in the economy at a given price level for a given period
- AD = C + I + G + ( X - M )
why is the AD curve downward sloping?
(3)
- there is an inverse relationship between price level and real GDP
- wealth effect
- trade effect
- interest effect
- what is the wealth effect say?
-As the price level decreases, the purchasing power of income increases,
- so they’re more likely to spend money on g & s
-increasing the level of consumption
- what does the trade effect say?
As the price level decreases, exports
become more competitive and imports
become less competitive.
- this means there will be a greater demand for exports
-and the revenue from exports
increases extending AD
- what does the interest effect say
-As price level decreases, interest rates can be kept lower
- because most central banks will adopt interest rate policies to meet an inflation rate target,
-lower interest rates stimulates higher consumption and investment ( because cost of borrowing is lower )
-and reduces the value of the exchange rate boosting export performance
when does the AD curve shift?
When c, i, g, or (x-m) change independent of the price level
what percentage of AD does consumption account for?
66%
what reasons are there for why the level of consumer spending can increase or decrease dependent of price level? (5)
- level of real disposable income
- interest rates/ availability of credit
- consumer confidence
- asset prices
- household indebtedness
- saving
explain how the level of real disposable income can grow or shrink levels of consumption
- disposable income can increase if their are cuts in the marginal rate of income tax
- or increases in tax free allowance
- increasing the marginal propensity to consume
- increasing the level of consumption
explain how interest rates can impact the level of consumer spending(7)
- if interest rates are cut, the cost of borrowing falls and the rate of return on saving falls
- if the cost of borrowing falls, it increases the incentive for consumers to go and borrow money because it’s cheaper to do so
- this money will be spent on more expensive items such cars and houses
- the rate of return on saving decreases, reducing the incentive to save
- instead any income generated may go into consumption
- if interest rates are cut monthly repayments could fall for households that have variable rate mortgages or tracker rate mortgages
- monthly they have more disposable income to spend in economy
explain how the availability of credit can impact the level of consumption
(2)
- if availability of credit is low, it can reduce the impact of borrowing and lower interest rates
- because banks are not willing to lend
explain how consumer confidence can impact the level of consumer spending
- if there is high consumer confidence consumers have a higher marginal propensity to consume
- if people’s job prospects are strong their mpc is going to be higher
- if the level of unemployment is very low then individuals will feel confident in their job prospects
how can asset prices affect the level of consumer spending? (4)
- the wealthier people feel, the higher their marginal propensity to consumer
- if things such as house prices and share prices rise and individuals hold these assets they feel wealthier
- so they’re more likely to spend money
- this is especially true for the UK
how can household indebtedness affect the level of consumer spending?
- if there is a large number of households living in huge debts
- individuals are more likely to save their money instead of spend their money
- incase they need to repay debts quickly
what are the determinants of saving? and explain
- level of real disposable income (if incomes rise, levels of saving can rise)
- interest rates (higher interest rates encourages saving because rate of return increases)
- consumer confidence ( if consumer confidence is low because people fear a recession, loosing their jobs or an income cut they’re going to save )
- range and trustworthiness of financial institutions (in developing countries financial institutions like banks are often corrupt or unofficial reducing incentive to save) (education- knowing the benefits)
- Tax incentives (such as ISA’s where you can earn returns on savings tax free up to a certain threshold encourages saving )
- Age structure of population ( middle age people are more likely to save for their children whereas the younger generation are more likely to spend )
what are the determinants of investment? (6)
- interest rates
- business confidence
- corporation tax
- spare capacity
- level of competition
- price of capital
what is investment?
when firms spend money on capital goods to increase their productive capacity
- how do interest rates effect the level of investment? (2)
- what is the hurdle
- link interest rates and the hurdle
- -if interest rates are low in the economy, the cost of borrowing is low
- so firms have a greater incentive to borrow money and invest - the required rate of return firms need for investment projects to go ahead
- if interest rates are lower reaching the hurdle is easier
- increasing the mpc to invest
how does the levels of business confidence effect levels of investment? (3)
- if the expectation of profit and demand in the economy is high going forward
- businesses mpc to invest will be higher to meet that level of demand in the future
- incentivising investment
how does corporation tax effect the levels of investment?
- the lower the corporation tax, the higher the level of retained profit is going to be
- the greater potential the business has to invest
how does spare capacity effect the level of investment (3)
- if business have lots of spare capacity there is no need to invest and buy more capital machinery
- the lower the mpc to invest
- lower the levels of investment
how does the level of competition effect investment?
- if levels of competition are strong and lots of competitors are innovating and improving their tech
- business will react to that and also invest to catch up to rivals
- stimulating investment
how does the price of capital effect the level of investment? (4)
- if price of capital is low
- investment is less costly
- mpi is high
- investment increases
what is the other determinant of investment?
accelerator effect
what are the factors of government spending? (4)
- current spending - maintenance of public services such as NHS and public sector wages
- capital spending - spending on infrastructure projects such as roads and airports
- welfare spending - biggest chunk for the UK, involves benefits such as unemployment, disability and pensions to the elderly
- debt interest payments that carry a huge opportunity cost around £55 B annually for UK
what are the 3 other determinants of Government expenditure?
- fiscal policy
- economic cycle
- political cycle
explain how fiscal policy determines government expenditure (2)
- government uses fiscal policy to influence AD
- in a recession the government could borrow more and spend on capital investment such as new roads and railways
explain how the economic cycle can influence government expenditure (2)
- in a period of high economic growth tax revenues tend to rise
- this gives the government more money to spend on services like the NHS
explain how the political cycle can influence government expenditure
- government may cut spending after and election
- to reduce the budget deficit
- but increase spending shortly before an election
what are the determinants of net exports? (5)
- real disposable income earned abroad
- real disposable income earned at home
- strong or weak exchange rates
- protectionism at home and abroad
- inflation levels at home
how would will real disposable income earned abroad impact the level of net exports ? (8)
- if there is a boom abroad
- individuals abroad are getting richer
- their marginal propensity to import will increase
- demand for exports will increase
- a recession in countries abroad especially the main trading partners of the UK such as the countries in the EU
- marginal propensity to import reduces
- revenues from UK exports reduces
how does the real disposable income earned at home impact net exports (4)
- If the UK has a boom
- marginal propensity to import in the UK rises (sucking in of imports)
- import expenditure likely to rise
- vice versa
how do exchange rates influence exports?
-SPICED, WIDEC
- imports cheap, exports dear
- demand for imports rises
- demand for exports will fall
- revenue generated from exports will fall
how would protectionism influence net exports thus AD ?
-strong protectionism abroad such as tariffs on UK exports
- prevents the UK from being able to enter international markets
- reducing export revenues
- strong protectionism in the UK
- reduces import expenditure
- reducing the value of imports shifting AD to right
how does relative inflation levels at home effect exports thus AD?
- if inflation in the UK is higher than inflation in economies around the world
- exports are going to be less competitive
- demand for exports is going to be lower
- export revenue generated will be lower
what is the classical view of LRAS?
- in the long run the economy operates at full capacity
- meaning that all factors of production are utilised
- aggregate supply is inelastic in the long term, instead demand mainly influences prices
what is the keynesian view of LRAS?
why is the curve upward sloping?
- sees AS as upward sloping and elastic
- argues that the economy can be below the full employment level even in the long run
- as the economy grows and demand increases
- businesses are willing to produce more goods and services, leading to higher prices
what factors shift sras?
(5)
- wages - wages decrease, costs of production decreases
- raw materials / commodity prices - price goes up, cost of production increase
- oil price - increased oil prices,
increases cost of production - business taxes (VAT)- VAT increases, increased costs of production
- import prices - SPICED, costs of production decrease, WIDEC costs of production increase
what are supply side shocks?
- factors that affect the costs of production
- this factors are very quick
- they can be positive or negative ( stagflation )
describe a classical supply curve (2)
- lras is vertical representing one level of output the economy will always produce at in the long run
- that level of output is YFE ( the maximum level of output an economy can produce using all factors of production at sustainable levels )
- this is measured by the natural rate of unemployment (4.5%)
how can LRAS shift?
-Q2CELL
- changes in the quantity or quality of the factory of production
give examples of Q2CELL
(6)
- labour productivity
- investment ( tech advances, research and development spending, software upgrades)
- infrastructure ( new roads, upgrading airports)
- quantity of labour ( large net inward immigration, incentives -reducing benefits and cutting income tax )
- competition ( privatisation, deregulation )
- new resource discoveries
what can cause LRAS to shift to the left?
(5)
- decrease in labour productivity
- mass capital depreciation ( firms may reconsider capital expenditure, lower asset values )
- war, conflict, natural disaster, pandemic ( reducing infrastructure and labour )
- hysteresis ( long term unemployment, workers become discouraged and drop out of labour force
- emigration
why is the keynesian upward sloping
- don’t believe in short run and long run supply
- believe that the economy can be producing less than YFE
- there is a point where we can reach full employment
- the shape bends due to the level of spare capacity in the economy
- for example if the economy is in a recession it is possible to increase production without there being any increase in inflationary pressures
- because there is mass unemployment of factors of production
- the closer we get to YFE the more we are using up spare capacity, the more pressure on existing factors of production
- e.g. labour is becoming scarcer so wages have to rise
when do we get macro economic equilibrium
AD = AS
