Models of the macroeconomy

Question 1

Explain the circular flow of income.

Answer 1

The Circular Flow of model demonstrates how money moves through society. Money flows from producers to works as wages and flows back to producers as payments for products. In short, an economy is an endless Circular Flow of money.

Question 2

The major difference between Microeconomics and Macroeconomics theory.

Answer 2

Microeconomics
1. Microeconomics theory looks at the individual units of the economy and focuses on the interaction among these units.
2. Microeconomics is concerned with the behaviour and decision-making practices of specific markets, industries, firms, individual consumers and households.

Macroeconomics
1. Macroeconomics is concerned with issues, objectives, and policies that pertain to the overall economy.
2. Macroeconomics targets mainly economic growth, full employment, price stability and a favourable external position.

Question 3

Calculation of Rate or Growth

Answer 3

New - Old / Old X 100

Question 4

What is National Income?

Answer 4

National Income is the sum of all the income made in the economy on an aggregate level. It is an essential measure of economic performance. By extention it is a measure of a country’s output, income and expenditure.

Question 5

What are the ( 3 ) methods of calculations of National Income.

Answer 5

• The Income Method
• The Expenditure Method
• The Output or Product Method

Question 6

What is The Income Method?

Answer 6

The Income Method is based on the total income in the form of wages, profits, rents and interests which accrue to individuals and businesses in a given country in a given year.

Question 7

What is The Income Method?

Answer 7

The Expenditure Method is based on the total spending on goods and services by individuals and businesses in a given country in a given year.

Question 8

What is the The Output Method?

Answer 8

The Output Method is based on the total value of goods and services produced in a given country in a given year.

Question 9

The Identity?

Answer 9

Each method should give the same result since the flow of expenditure on goods and services should be identical to the same value of goods and services and identical to the incomes paid by firms.
Example
In other words if I spend $50 on goods and services this is equivilent to the same value of these items and is also equivilent to what would have been paid out to firms for employing their services. Expenditure is identical to the value of output and is identical to income. In reality because of measurement problems the (3) estimates of National Income diverge.( they are different )

Question 10

What is Market Prices?

Answer 10

Market prices are prices which include taxes (taxes on expenditure) and may exclude the value of subsidies. The price paid for the good may not be a true reflection of the factor cost.

Question 11

What is the calculation for Factor Cost?

Answer 11

Factor Cost = Market price - Indirect taxes + Subsidies.

Question 12

What is Stock Appreciation?

Answer 12

This involves inventories ie. goods produced by a firm which are not sold. These are valued at their market prices, the price they would currently fetch if they were sold. Thus the difference between the cost of production and the market price shows up in the profit figures.

Question 13

What is Residual Error?

Answer 13

NI statistics are only estimates of what has happened in the eonomy. Mistakes in data collection inevitably occur, so a residual error or mistakes item must be included.

Question 14

What is Depreciation?

Answer 14

This results from the fact that parts of this year’s stock will be worn out in producing this yea’s National Income.

Question 15

What is Gross Domestic Product?

Answer 15

The total valu of output produced within the borders of a country, in one year, using the resources within the country. It includes that which is produced by nationals and foreigners.

Question 16

What is Gross National Product?

Answer 16

The total value of output produced using the resources owned by the nationals of a particular country, wherever these resources are located.

Question 17

What is Gross Investment?

Answer 17

The total output of capital goods within a given period of time.

Question 18

What is Net Investment?

Answer 18

This is the net addition to the capital stock. It is gross investment minus depreciation.

Question 19

Net investment calculation

Answer 19

Gross Investment - Depreciation

Question 20

What is Investment?

Answer 20

This is the creation of real capital assests.Under this heading we must also include additions to stock and work-in-progress. ( Gross Fixed Capital Formation )

Question 21

What is Real GDP calculation?

Answer 21

Nominal GDP / Price Index ( in hundredth )

Question 22

Personal Income calculation

Answer 22

NNP + Transfer Payments - Retained Earnings - Corporate Tax.

Question 23

Disposable Income calculation

Answer 23

Personal Income - Income Taxes

Question 24

GDP per Capital calculation

Answer 24

GDP / Total Population

Question 25

Explain the concept of GDP and Inflation?

Answer 25

To calculate GDP economist attempts to measure the value of final goods and services produced in the economy. This valuation can be based on both the quantity of final output produced and the current price of the output.
The use of prices that presently exist gives nominal GDP.

Using nominal GDP means that it would be impossible to know exactly whether an increase in the statistic is due to an increase in the volume of output or an increase in the current prices of such output.
To overcome this problem the GDP deflator or Price Index is used. This removes the effects of price changes in the measurement of National Income.

Question 26

What is Nominal GDP?

Answer 26

Nominal GDP is the valuation of goods and services in the economy based on the current prices of these goods and services.

Question 27

What is Real GDP?

Answer 27

Real GDP measures the value of goods and services at constant prices. It is a better indicator of the level of economic activity. Real GDP measures the increase in the quantity or volume of goods and services produced.

Question 28

What is Real GDP calculation?

Answer 28

Real GDP = Nominal GDP / GDP deflator X 100

Question 29

Define the term equilibrium output.

Answer 29

This is the level of output [ Y ] that is equal to the level of demand [AD ] within the economy.
When Y = AS = AD the economy is in equilibrium as the supply of goods and services matches the demand for goods and services.

Question 30

Outline ( 2 ) factors that could account for volitility of investment spending.

Answer 30

1. Expectations of the future - if the investors believe that the economy is likely to have strong in the future - they will invest in new projects; but if they preceive a bleak future, they might reduce the level of investment spending due to the uncertainty.
2. Fluctuation in interest rates - when the interest rates are low, investors are likely to borrow to spend on new projects; however, when interest rates are high or rising, they are very unwilling to risk borrowing at the higher rates.

Question 31

Differentiate between the ‘Investment Curve’ and the ‘Investment Demand Curve’ for an economy.

Answer 31

The Investment demand curve leans downward to the right to reflect the inverse relation existing between interest rates and investment. The investment demand curve shows the combination of interest rates and levels of investment that occur at equilibrium income ( output ).

The Investment curve (IS ) shows the level of output ( Y ) that is expected as a result of a change in the investment interest rate , thus the multiplier effect on income (output) . A small increase in interest rates may result in a large demand for investment funds.

Question 32

The relationship between the marginal propensity to consume (MPC) and marginal
propensity to save (MPS).

Answer 32

The relationship between the MPC and MPS is inversely proportional [i.e as one increases the other automatically decreases ]
Hence MPC+MPS= 1
where 1 represents the change in income.

Question 33

Why does the information from the table describes Investment Demand Curve?

Answer 33

The table is showing that as the interest rate falls, the amount of expected investmnet in the economy increses substantially.

Question 34

TWO ways in which businesses adjust their level of inventory investment if the level of GDP is in disequilibrium.

Answer 34

Most businesses plan their inventory investment ( i.e future expectation of earning ) - thus, disequilibrium in GDP may result in there being insufficient inventory or overstock of inventory.

1. Where output is less than aggregate demnad [ Y < AD ], businesses will try to boost production (invest more) as there is insufficient planned inventory to meet the increase demand in the economy. This may need an increase in prices to reduce demand until equilibrium is restored.
2. Where output is greater than aggregate demand [ Y > AD ], businesses will try to slow down or reduce production (invest less) as there is unplanned inventory which they need to dispose of since demand in the economy had declined. This may be facilitated by lowering prices which will eventually stimulate demand until equlibrium is restored.

Question 35

TWO ways in which the economy adjusts withdrawals if the level of GDP is in
disequilibrium.

Answer 35

When the disequilibrium is caused by an increase in savings, there is a shortage of money in the domestic circular flow.

• In order to adjust this, the economy may experience a lowering of interest rates to encourage borrowing for investment and/or consumption of locally produced goods (i.e try to stimulate opportunities and/or a willingness to consume (spend money rather than save it)

When the disequilibrium is caused by an increase in importation of consumable goods, then that money is no longer in the domestic circular flow.

• The economy may address this situation by imposing restrictions or taxes on the foreign goods; and at the same time provide incentives to get local producers to make their goods more competitive and/or to encourage local consumers to want to buy more locally produced goods [e.g Buy Local Campaigns]- in order to increase expenditure in the domestic economy.

Question 36

Last Topic of MODULE 1- INVESTMENT

Investment/Gross Fixed Capital Formation

Answer 36

Spending on new machinery, factor assests such as machinery, plant, vehicles and other capital goods which result in increase in the production of goods and services in the future time period.

Question 37

Changes in Investment

Answer 37

If aggregate demand for final goods < aggregate supply ~ Inventories increases.
If aggregate demand for final goods > aggregate supply ~ Inventory falls.

Question 38

Actual or Gross Investment calculation.

Answer 38

GFCF ( planned investment ) + change in inventories ( unplanned investment )

Question 39

Net Investment Calculation and definition.

Answer 39

Gross Investment - Capital Consumption

• Net Investment is the true addition to the national stock of capital used to move the economy forward.

Question 40

Depreciation/Capital Consumption

Answer 40

This occurs because:

• Capital wears out due to use and needs to be replaced. It eventually needs to be disposed or overhauld.
• Capital becomes less productive due to technological obselence.

Question 41

Investment spending includes?

Answer 41

• Construction
• Construction of residental and commerical buildings
• Work-in-progress, semi-finished goods (additions to stock or inventory)
• Public investment in roads, ports and schools.

Question 42

Replacement Investment.

Answer 42

At the economic level investment spending is undertaken to replace worn out or depreciated capital and to expand the capital stock known as net investment

Question 43

[Investment ] ~ Induced

Answer 43

Based on Y

Question 44

[Investment] ~ Autonomous

Answer 44

Not based on Y but factors like the ROI and future expectations.

Question 45

Accelerator Theory

Answer 45

Investment is more volitile than national output and the accelerator theory seeks to explain this volitility.

The acceleratory theory implies that a slowdown in consumer spending or export causes a decline in the rate of increase in NI and a declinein Investment.

Question 46

Investment expressed as a function of income

Answer 46

It = b (Yt - 1)

It = Investment in time
b = Capital to output ratio
Yt = Output in time
Yt - 1 = Output in year before

Question 47

Assumptions of Accelerator Theory:

Answer 47

• Fixed Capital to Output ratio
• Investment is induced by income. As income increases investment are necessary to maintain the fixed capital to output ratio.
• Planned Capital Investment spending is demand induced meaning that the demand for new plant and machinery comes from the demand for goods and services. [ Derived Demand ]

Question 48

What is GDP?

Question 49

What is GNP?