mini test

Question 1

Circular Flow of Income

Answer 1

A model of the economy which shows the movement of goods and services between households and firms and their corresponding payments in money terms

Firms to households:
-wages
-dividends(profits)
-provide goods and services

Households to firms :
-consumption expenditiure
-Factors of production

Question 2

National Output (O)

Answer 2

The value of the flow of goods and services from firms to households

Question 3

National Expenditure (E)

Answer 3

The value of spending by households on goods and services

Question 4

National Income (Y)

Answer 4

The value of income paid by firms to households in return for land, labour and capital

Question 5

Injections and Withdrawals

Answer 5

-Injection - this is the spending in the circular flow that does not come from households. There are three sources of injections:
1. Investment
2. Government spending
3. Exports

-Withdrawals (or leakage) - there are 3 sources of withdrawals to correspond to the three injections:
1.Saving by households
2.Taxes
3.Imports

Economic equilibrium when injections = withdrawals

Question 6

Government budget deficit

Answer 6

When the government is spending more than they receive in tax, this is a budget deficit. (not a current account deficit)

Question 7

What is the likely impact of a government deficit on the circular flow of income

Answer 7

Budget deficit refers to government spending which is greater than government revenue ie from taxation. The budget deficit is a net injection as there is more money flowing around the circular flow, therefore AD increases

Question 8

Output Gap

Answer 8

The output gap is the difference between the actual level of GDP and its estimated potential level.
The output gap is usually measured as a percentage of the level of potential output.

Question 9

Negative Output Gap

Answer 9

-A negative output gap refers to a situation where an economy’s actual output or real gross domestic product (GDP) is below its potential output.
-Potential output represents the level of production an economy can achieve when all resources (labour, capital, technology) are fully employed without causing inflationary pressures.
-When actual output falls below this potential level, it results in a negative output gap.
-A negative output gap often corresponds to higher unemployment and under-utilized resources. It might also lead to disinflationary effects

Question 10

Positive Output Gap

Answer 10

-In economics, a positive output gap refers to a situation where an economy’s actual output or real gross domestic product (GDP) exceeds its potential output.
-Potential output represents the level of production an economy can sustainably achieve when all available resources (labour, capital, technology) are fully utilized without causing inflationary pressures.
-When actual output surpasses this potential level, it results in a positive output gap. This can lead to rising demand-pull and cost-push inflationary effects.

Question 11

Multiplier Process

Answer 11

• The multiplier effect happens where an initial change in spending, whether it’s from consumers, businesses, or the government, leads to a larger and more widespread final impact on an economy’s total output or income.
  *The multiplier effect illustrates how changes in spending can create a ripple effect throughout the economy, generating additional rounds of economic activity.
• When an individual increases its spending, the recipients of that spending then have more income, which they, in turn, spend on goods and services.
• This creates additional demand, which prompts businesses to increase production and hire more workers, resulting in higher factor incomes.

Question 12

Multiplier Process Examples

Answer 12

The government injects £200m in a project to build thousands of affordable new houses. This is an expansionary fiscal policy designed to stimulate aggregate demand and economic growth.

-A new house building project injects £200m of extra demand and output into the economy
-Many businesses benefit directly including building supply industries, architects etc.
-Constructing new houses generates a new flow of factor incomes - including wages and profits
-Will the extra incomes stay inside the circular flow of income and spending? This is key!
-If so, the multiplier effect is likely to be strong and resultant final impact on GDP quite large

Question 13

The Multiplier

Answer 13

The multiplier is defined as the final change in equilibrium national output resulting from an initial change in AD.

Question 14

Positive Multiplier effect

Answer 14

when an initial increase in an injection ( or a decrease in a leakage) leads to a greater final increase in the level of real GDP

Question 15

Negative Multiplier effect

Answer 15

When an initial decrease in an injection (or an increase in a leakage) leads to a greater final decrease in the level of real GDP.

Question 16

Formula for the multiplier in a closed economy with no government

Answer 16

Multiplier = 1 / marginal propensity to save

-we know that the MPTC and TS must equal 1
-Disposable income can be spent or saved
-MPS + MPC = 1, therefore MPS = 1- MPC
-therefore the multiplier formula can be written as:
Multiplier = 1 / (1-MPC)

Question 17

Formula for multiplier in open economy with a government sector

Answer 17

Multiplier = 1 / MPS + MPM + MRT

In an open economy with a government sector, there are 3 withdrawals from the circular flow:
1. Savings ( marginal propensity to save)
2. Imports ( marginal propensity to import)
3. Taxation ( marginal tax rate on income)

Question 18

What Factors Affect the Multiplier value

Answer 18

*Marginal Propensity to Consume (MPC): A higher MPC leads to a larger multiplier effect because a greater proportion of any initial increase in income is spent, leading to multiple rounds of increased spending and output.
*Leakages: Leakages from the circular flow, such as saving, taxes, and imports, reduce the size of the multiplier. If people save a significant portion of their additional income, or if a substantial portion of the increased spending leaks out of the economy in the form of taxes or imports, the multiplier effect will be smaller.
*Degree of Spare Capacity: If an economy is operating close to its full potential (with little
spare capacity), the multiplier effect might be limited.
* Time Frame: In the short run, factors like capacity constraints and rigidities in adjusting production can limit the multiplier’s size. In the long run, adjustments in production capacity, investments, and resource allocation can lead to a larger multiplier effect.

Question 19

High and Low values for the multiplier

Answer 19

High Multiplier value when:
-Economy has plenty of spare capacity (a
negative output gap) to meet higher
aggregate demand
-Marginal propensity to import and tax is low (important leakages)
-High propensity to consume any extra
Income (people have a low marginal propensity to save)

Low multiplier value when:
-Economy is close to capacity limits during a boom phase of an economic cycle
-Propensity to import goods and services is high- this means extra demand leaks from circular flow
-Higher inflation causes rising interest rates which then dampens the other components of AD

Question 20

Multiplier and elasticity of Aggregate supply

Answer 20

When SRAS is highly elastic, the multiplier effect is likely to be
high following an increase in an injection of demand.
When SRAS is inelastic, it is
harder for supply
to expand to meet a rising level of AD