Module 13 - The Circular Flow of Income

Question 1

Define the Short-run theory of income determination.

Answer 1

• Assumes production possibilities frontier is fixed and technical knowledge is unchanging
• Actual income is determined by aggregate demand
• Relationship between aggregate demand and aggregate supply determines whether

o Unemployment and unrealised potential

o Full employment at capacity

o Overfull employment and rising prices

Question 2

Explain the duel-role of households

Answer 2

• All households are consumers
• Some households are Resource owners

o Land, labour, capital goods, enterprises

Question 3

Name the two groups of markets for goods and services

Answer 3

Two groups of markets for goods and services

• That producers buy from households
• That producers sell to households

Question 4

Name the double circular of flow.

Answer 4

• Goods and services / Expenditures
• Income / Factor services

Question 5

What is Net National Product (NNP)?

Answer 5

Net National Product (NNP) = GNP - Depreciation

GNP/NNP only include final goods and services to avoid double counting. Intermediate goods and services are excluded.

Question 6

GNP can be calculated in 3 different ways, name them:

Answer 6

• GNE: total amount spent by households, governments, firms… on final goods and services, eliminate intermediate sales
• GNP: sum of values added by producers
• GNI: income paid to primary factors of production

o Wages and salaries

o Rent (land)

o Interest

o Gross profits

Question 7

Equivalence of national income and national output is a consequence of ___ as ___

Answer 7

definition of profits;

residual

Question 8

Income received must be sufficient to purchase all ___

Answer 8

output produced.

The equivalence between national output and national income is a consequence of definition of profits as a residual, obtained after deducting from the value of output all other factor incomes: wages and salaries, rent, interest and dividends. Given that profits are the residual, it follows that the sum of all factor incomes – wages and salaries, rent, interest, dividends, and profits – must equal the value of national output. In other words, the whole of the value of output must accrue as a factor income to some household; or, to put it another way, the income enjoyed by a community is determined by the flow of final goods and services it produces.

Question 9

Business can only sell if income is translated into ___. The level of sustainable output dependent on ___.

Answer 9

effective demand (actual expenditure);

expenditure

Question 10

Define Consumption.

Answer 10

Consumption (C) consists of expenditure on goods and services to satisfy current needs. Complications are introduced by expenditure on consumer durables that yield a flow of services over time, e.g. a car; we shall ignore consumer durables, therefore, for the sake of clarity.

Question 11

Define Savings.

Answer 11

Savings (S) is income not spent on consumption, i.e. it is the residual obtained by subtracting consumption from household income.

Question 12

Define Income.

Answer 12

Income (Y): it follows that income has two components, consumption (C) and saving (S) so that: Y ≡ C + S

Question 13

Define Investment.

Answer 13

Investment (I) is the production of goods that are not used for consumption purposes; these goods are known as investment goods.

There are two main catego- ries of investment goods: inventories and capital goods:

(a) Inventories: most firms hold stocks of inputs required in the production pro- cess and stocks of their output. These stocks reduce delays in meeting production targets and in meeting customers’ orders. Changes in inventories are considered as part of investment, because they represent changes in the volume of goods produced that are not used for current consumption. An in- crease in inventories represents additional investment, while a reduction in inventories represents disinvestment. Changes in inventories can be intended or unintended. If a firm decides to increase (decrease) output, it is likely to in- crease (decrease) its inventories of inputs and outputs. In this case, the change in inventories is intended or planned. Alternatively, the change in inven- tories may result in an error from forecasting sales – for example, if sales are less than expected, stocks of outputs will rise, and such investment is unintended or unplanned.
(b) Capital goods: the productive capacity of an economy is partly dependent upon its capital stock, consisting of factories, offices, machine tools, airports, har- bours, roads, railways, etc. Investment includes the production of all new capital goods. As has been previously stated, investment may be to make good depreciation, or it may involve net addition to the stock of capital goods.

Question 14

Define Total (gross) Investment.

Answer 14

Total (gross) Investment (I) thus includes investment in inventories and investment in capital goods:

Gross Investment = replacement investment

Question 15

Savings are a withdrawal from ___ .

Answer 15

circular flow of income;

Contractionary effect (reduces national income)

Thus, savings do not constitute a component of aggregate demand (expenditure) and the act of saving does not create a demand for output, thereby generating income and employment.

Question 16

If we suppose initially that all income is consumed, then:

Answer 16

(a) all value added (output) would accrue to private households and factor incomes; and
(b) all factor incomes would be used by households to purchase consumption goods and services provided by business firms (producers).

Question 17

Investment is an ___

Answer 17

injection

On the other hand, investment is an injection into the circular flow of income. It is part of aggregate demand (expenditure), as the act of investment creates a demand for output and results in income and employment creation.

Question 18

Any injection has an ___ on the level of national income

Answer 18

expansionary effect

Any injection has an expansionary effect on the level of national income. The act of investment does constitute part of aggregate demand, as it creates a demand for investment goods and results in income and employment. A rise in investment will, other things being equal, tend to increase national income, and vice versa

Question 19

It follows from this that equilibrium national income can only be achieved when there is consistency between ___ and the ___

Answer 19

the plans of savers;

plans of investors

If planned saving (assumed to be undertaken by households) and planned investment (assumed to be undertaken by business firms) are equal, then national income will be in equilibrium and will show no tendency to change. If planned savings and planned investment are not equal, national income cannot be in equilibrium and, instead, must change – and must continue to change until the equality of planned saving and planned investment is achieved.

Question 20

A change in planned savings and/or planned investment will produce a change in national income. Discuss.

Answer 20

(a) an increase in planned saving will produce a reduction in national income, unless it is offset by an increase in planned investment;
(b) a reduction in planned saving will produce an increase in national income, unless it is accompanied by a reduction in planned investment;
(c) an increase in planned investment will produce an increase in national income unless it is offset by an increase in planned saving;
(d) a reduction in planned investment will produce a reduction in national income, unless it is accompanied by a reduction in planned saving.

Question 21

Motive for saving often different from motive for investment, explian.

Answer 21

The desire to save not determined by availability of real investment opportunities.

In addition, a firm may retain profits not to invest in the current period but to finance investment at an unspecified future date, or as a precaution against some anticipated or unforeseen adverse development in trading conditions, or to improve the liquidity position of the firm. Individual households may save to buy some goods in the future; to protect against a ‘rainy day’ (including becoming unemployed); because they have contracted into some insurance or savings pro- gramme; to leave wealth for their children; or through sheer miserliness

The desire to save is not determined by the availability of real investment opportunities, namely the likely profitability of investment in inventories or capital goods. But, in contrast, it is precisely the prospect of such profitability that determines investment. Investment takes place in the expectation of profitability and the volume of investment is clearly a function of the availability of investment opportunities.

Question 22

In year 1 an economy is operating on its production possibilities frontier. In year 2 the level of technology, the capital stock and the labour force are the same as in year 1 (i.e. the production possibilities frontier has not moved) but output is lower than in year 1.

This means that

I. at least one resource must not be fully utilised.
II. the output of capital goods must have decreased.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 22

The correct answer is A. Given that the production possibilities frontier has not shifted, the economy is capable of producing the same amount of goods and services (national output) in year 2 as in year 1. However, since national output is lower, the economy is no longer on its production possibilities frontier and some resources are not being fully utilised. Thus, unemployment of labour and/or capital exists in the economy. It is possible that the output of both consumption goods and capital goods has decreased, but not necessarily. If the output of consumption goods decreases more than the amount by which the output of capital goods increases, the effect will be a fall in total output, and so II is not necessarily correct.

Question 23

In the circular flow of income, households

I. purchase goods and services.
II. sell labour and capital services.
III. invest in plant and equipment.

Which of the following is correct?

A. I only.
B. I and II only.
C. III only.
D. I, II and III.

Answer 23

The correct answer is B. In the circular flow of income, households serve a dual purpose: from firms they buy goods and services, and to firms they sell the services of their labour, land and capital. The decision to invest in plant and equipment is made by firms, not by households.

Question 24

In the theory of income determination

I. the excess of expenditures on goods and services by consumers over the value of the goods and services consumed equals the returns to factors of production.

II. the returns to factors of production minus the value of goods and services produced provides investment resources.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 24

The correct answer is D. Returns to factors of production equal the value of final goods and services produced, i.e. national income equals national output; thus I is false. Total output minus the value of goods and services consumed determines what resources are available for investment; thus II is false.

Question 25

If, in a certain economy, the flow of goods and services equalled £200 billion, it follows that

A. the value of the capital stock was £200 billion.
B. the value of labour services was £200 billion.
C. national income was £200 billion minus depreciation.
D. expenditure on final goods and services was £200 billion.

Answer 25

The correct answer is D. National income is a flow that can be measured in three ways: by value added in each activity (output), by the incomes accruing to factors of production (income), and by expenditure on all final goods and services (expendi- ture). The three methods of measuring national income must, by definition, yield the same result, errors of arithmetic apart. Hence the money value of the flow of goods and services (£200 billion) must equal the money value of expenditures on goods and services (£200 billion).

Question 26

In a simple two-sector model of an economy, the higher the level of

I. national income, the higher the level of national output.

II. national output, the higher the level of national expenditure.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 26

The correct answer is C. National income is a flow that can be measured in three ways: by value added in each activity (output), by the incomes accruing to factors of production (income), and by expenditure on all final goods and services (expendi- ture). The three methods yield identical results provided there are no arithmetical errors.

Question 27

For which of the following is the simple two-sector model of the economy useful? To show

A. the equality between expenditure on goods and expenditure on services.

B. that households and firms have conflicting interests.

C. the equality between national income and national expenditure.

D. that wages + salaries equals expenditure on final goods and services.

Answer 27

The correct answer is C. The simple two-sector model of the economy demonstrates the circular flow of income and expenditure, in which the flow of income to households from producers for the use of their resources must be equal to the flow of expenditure from households to producers for goods and services purchased. The simple model does not demonstrate any necessary conflict between households and firms. The distribution of expenditure between goods and services will depend on tastes, and only by chance would lead to equality of expenditure on the two categories. Finally, wages and salaries are only one receipt of households, which also receive other income from land and capital.

Question 28

Calculation of Gross National Product includes

I. purchase of 100 shares in IBM by a company pension fund.

II. purchase of $1 million of machine tools by car companies.

III. the accumulation of tractors by the manufacturers in their warehouse. Which of the following is correct?

A. I only.
B. II only.
C. II and III only.
D. I and III only.

Answer 28

The correct answer is C. The purchase of machine tools and the accumulation of goods produced by a company in inventory are both included as investment expenditure. In purchasing shares, claims to assets are exchanged for cash and such a transaction creates no new goods or services.

Question 29

Last year all the bakers in an economy produced bread which sold for $55 million. The value of the flour required for the bread was $35 million and the value of the wheat
required for the flour was $20 million. The contribution to GNP of the bread industry last year was which of the following?

A. $5 million.

B. $50 million.

C. $55 million.

D. $105 million.

Answer 29

The correct answer is C. Gross National Product (GNP) consists of the flow of all final goods and services produced in a given period. It therefore consists of con- sumption and investment goods but excludes intermediate goods, which are used only to produce final consumption or investment goods. Bread is a consumption good; hence the value of bread produced is part of GNP. However, flour and wheat are intermediate goods whose values are reflected in the price of bread. To include in the GNP accounts the value of bread, flour and wheat produced would be to count the flour twice and the wheat three times.

Question 30

For any particular receipt to be counted as part of the national income of an economy, which of the following must be true?

It must

A. be in return for a currently produced good or service.
B. be in return for the use of resources in the production of current output.
C. represent payment on borrowings.
D. represent an increase in the resources of the recipient.

Answer 30

The correct answer is B. National income is the sum of income accruing to factors of production. Thus for a receipt to be included as part of national income, it must be in return for the use of a resource in the production of current output. It could represent a payment on borrowing (i.e. return to capital) but need not. Payment for a good or service is part of Gross National Expenditure. It cannot represent an increase in the recipient’s resources as it is a return for services rendered from existing resources; the recipient could add to his stock of resources in the future by, for example, using the income from his labour services to purchase more capital goods.

Question 31

Which of the following is correct? The sum of all expenditures on final goods and services is equal to

A. all income paid out as wages and salaries.
B. the sum of money in circulation.
C. the total of all ‘values added’ at each stage of production.
D. disposable income plus investment expenditures.

Answer 31

The correct answer is C. National income can be measured by summing the expenditure on all final goods and services, by summing the values added by each producer and by summing the incomes earned by each factor of production. Arithmetical errors apart, each of the three methods of calculating national income will yield the same result. Hence summing expenditures on final goods and services is one method of measuring national income, and the result must be equal to the result obtained by summing values added at each stage of production. The income paid out as wages and salaries does not amount to national income because it excludes payment to other factors of production. Disposable income is a receipt, while investment is an expenditure. The sum of money in circulation and bank deposits is always substantially less than expenditures on final goods and services in a normal accounting period, since the same unit of money can be spent many times over within a single accounting period.

Question 32

In theory, Gross National Income (GNI) equals Gross National Expenditure (GNE). In constructing the National Income Accounts, such equality is attained normally by
including a ‘residual error’ term. This procedure is necessary to achieve balance because of which of the following?

A. It is necessary to subtract savings from GNI to arrive at total spending.

B. GNE includes spending on intermediate goods, whereas GNI is derived only from ‘values added’.

C. Although GNI and GNE each measure economic activity, statistical errors result in inaccuracies.

D. The wishes of savers may not match the investment plans of firms.

Answer 32

The correct answer is C. By definition, GNI equals GNE. Thus an inequality in practice must be due to errors and omissions. Since GNI is found by adding together all factor incomes, and GNE by adding together all final expenditures, it is inevitable in the real world that discrepancies will occur. A ‘residual error’ item is included in national income accounts to ensure equality. This residual error is sometimes called the ‘statistical discrepancy’.

Question 33

If all sales in an economy were to be added up for a particular year, which of the following would be true with respect to the grand total? It would

A. exceed GNP.
B. equal GNP.
C. be less than GNP.
D. equal GNP plus sales tax.

Answer 33

The correct answer is A. Since only sales of final goods and services are summed to yield GNP, the further addition of sales of intermediate goods and the sales of assets, i.e. goods produced in past periods, would yield a total greatly in excess of GNP.

Question 34

Assuming inventories are constant, if replacement investment is less than gross investment in a given year, then

I. net investment is positive.
II. net investment is negative.
III. the productive capacity of the capital stock is increasing.

Which of the following is correct?

A. II only.
B. III only.
C. Both I and III.
D. Both II and III.

Answer 34

The correct answer is C. Replacement investment is that investment which is necessary to make good any depreciation and maintain the productive capacity of the existing stock of capital goods. Net investment is the difference between gross and replacement investment, i.e. gross investment − replacement investment = net investment. Net investment can be positive, zero or negative depending on whether gross investment exceeds, is equal to or is less than replacement investment. When replacement investment is less than gross investment, then net investment is positive. This means that gross investment is sufficient to make good any deprecia- tion and add to the productive capacity of the existing capital.

Question 35

National income equals national output only when I. planned saving equals planned investment. II. the amount of consumer goods produced equals the amount of consumer goods bought.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 35

The correct answer is D. National income by definition equals national output. If more consumption goods are produced than people wish to purchase, the excess will be added to stocks, causing investment to increase. This process ensures that actual saving must always equal actual investment. It does not guarantee, however, that planned saving will always equal planned investment.

Question 36

Which of the following describes a ‘closed economy’?

Exports and imports are

A. equal.
B. fixed.
C. both zero.
D. dependent on government policy.

Answer 36

The correct answer is C. A ‘closed economy’ is one in which there is no international sector, i.e. one in which there are no imports and no exports.

Question 37

A survey carried out in Year t gathered information about the intentions of firms to invest and individuals to save. It was found that planned saving was greater than planned investment. However, in the national accounts for Year t + 1 it was found that saving and investment were equal.

Which of the following is the reason for this?

A. Businessmen must have lied about their intentions.
B. Households must have lied about their intentions.
C. Unintended stocks accumulated in Year t + 1.
D. It was purely a coincidence.

Answer 37

The correct answer is C. If people buy fewer goods and services than businesses expect them to, unsold goods will be added to investment expenditure in the form of unintended stocks. Thus actual investment expenditure will be greater than planned investment expenditure. Since saving is that part of income not spent, and since the amount of goods sold equals the amount of goods bought, actual saving must equal actual investment.

Question 38

National Income ≡ C + S
National Output ≡ C + I

Given the above identities, when the amount of consumer goods produced exceeds the
amount of consumer goods purchased

I. unintended inventories of consumer goods will occur in firms.

II. planned savings will exceed planned investment.

III. actual investment will exceed actual savings.

Which of the following is correct?

A. II only.
B. I and II only.
C. II and III only.
D. I, II and III.

Answer 38

The correct answer is B. If people buy fewer goods and services than businesses expect them to, unsold goods will be added to investment expenditure in the form of unintended stocks. Thus actual investment expenditure will be greater than planned investment expenditure. Since saving is that part of income not spent, and since the amount of goods sold equals the amount of goods bought, actual saving must equal actual investment.

Question 39

A change in the equilibrium level of national income in the short run will occur if there is an increase in

I. private sales of second-hand cars.
II. the rate of saving.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 39

The correct answer is B. Increased private sales of any item produced in previous time periods will not affect the equilibrium level of national income because such transactions are not included in the national accounts. An increase in the rate of savings will be matched by a decrease in consumer expenditure, thus reducing the equilibrium level of national income.

Question 40

Saving is a leakage from the flow of income in the economy because

A. it is typically a lower proportion of income than consumption spending.
B. it is never channelled into useful spending.
C. it is that part of income that is not currently spent.
D. it is usually greater than investment spending.

Answer 40

The correct answer is C. Saving, in the national income accounting sense, is defined as the part of income that is not consumed, i.e. Y − C = S where Y is income, C is consumption and S is savings. Savings are that part of income that is not currently spent and are thus a leakage from the flow of income. Investment expenditure, which is made possible by savings, is an injection to the flow.

Question 41

Which of the following is the best description of macroeconomic equilibrium?

A. Full employment.
B. Full capacity utilisation.
C. Any level of national income at which there are no forces acting to bring about a change.
D. That level of national income at which net investment is zero.

Answer 41

The correct answer is C. Equilibrium is a situation from which there is no tendency to depart. Macroeconomic equilibrium occurs where national income is not chang- ing and where there are no forces tending to change it.

Question 42

In the short-run in macroeconomics it is assumed that
I. technical knowledge is unchanging
II. the position of the production possibilities frontier is fixed

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 42

The correct answer is C. To explain the relationship between actual and potential output at a given point in time it is useful, and not unrealistic, to assume potential output is fixed; this assumes the quality and quantity of the labour force and capital stock are given and unchanging as is the state of technical knowledge. Thus I is correct. The given technology assumption means the production possibilities frontier is fixed in the short-run. Thus II is correct.

Question 43

The two sector model of an economy consists of only two groups. Which of the following is correct? The two groups are

A. households and firms
B. households and government
C. firms and government
D. firms and producers of capital stock

Answer 43

The correct answer is A. This is a definitional question. The two sector model consists only of households and firms; government is excluded. Thus B and C are incorrect; firms are producers of capital stock; thus D is incorrect.

Question 44

If consumption expenditure (C) were to exceed net national product (NNP)

I. the stock of capital assets would decrease?
II. net national product would exceed gross national product (GNP)?
III. depreciation of the stock of capital assets would decrease?

Which of the following is correct?
A. I only
B. I and III only
C. II only
D. I, II and III

Answer 44

The correct answer is A. GNP − depreciation = NNP. If C > NNP insufficient resources would remain to produce capital goods to replace those worn out in the production process. The capital stock would decline therefore. Thus I is correct. If depreciation were zero NNP would equal GNP but could never exceed it. Thus II is incorrect. Depreciation of the capital stock is either partly ‘time’ determined e.g. depreciates independent of use (wooden window frames) or increases with degree of utilisation; if C > NNP there would be no idle capital equipment and its depreciation might increase but certainly wouldn’t decrease. Thus III is incorrect.

Question 45

A. $310b?
B. $320b?
C. $340b?
D. $740b?

Answer 45

The correct answer is C.

GNP ≡ C + I + G + X − Z   ≡ 250 + 40 + 40 + 10   = 340

The other items appear in the factor income approach (compensation of employees, indirect taxes) or the output approach (manufacturing output)

Question 46

If in year t GNP were $100bn and in year t + 1 were $98bn then, assuming full employment of resources in year t,

I. at least one resource must have been operating at less than capacity in year t + 1
II. planned savings in year t did not equal planned investment

Which of the following is correct?
A. I only
B. II only
C. I and II only
D. Neither I nor II

Answer 46

The correct answer is D. A tricky one! Suppose in year t all resources were allocated to the production of consumer goods by firms and simultaneously all households planned to and consumed all their incomes. Thus both planned investment and planned savings would be zero. Thus II is incorrect. There would be no investment to make good depreciation of the capital stock and as a consequence the capital stock would decline leading to a smaller GNP in year t + 1 assuming no offsetting increase in the labour force. Thus full employment of resources could exist in both year t and year t + 1.

Question 47

Which of the following is correct?

Net investment would be negative if
A. potential output exceeded actual output
B. leakages from the circular flow of income exceeded injections into the flow
C. replacement investment exceeded gross investment
D. the unemployment rate rose and excess capacity appeared in the capital stock

Answer 47

The correct answer is C. The potential output of a nation is dependent partly upon its capital stock. In the process of producing goods and services depreciation of the capital stock occurs. To replace the depreciated capital requires replacement investment (RI). To enlarge the capital stock requires net investment also (NI). Total or gross investment (GI) is the sum of the two, i.e. replacement investment plus net investment, i.e. GI ≡ RI + NI. If RI > GI then NI must be negative; e.g. if GI were $10bn and RI were $15bn net NI would be −$5bn.

Question 48

In the simple two sector model firms

I. purchase final goods and services from other firms
II. purchase intermediate goods and services from other firms
III. purchase plant and equipment from households

Which of the following is correct?
A. I and II only
B. II only
C. I, II and III
D. Not I, not II, not III

Answer 48

The correct answer is B. In the circular flow of income only households purchase goods and services from, and sell labour and capital stock to, firms. Thus I is incorrect. Only firms produce final goods and services though they purchase intermediate goods and services from other firms in this process. Thus II is correct and III is incorrect.

Question 49

A rock group visited the campus last month, hired the auditorium for $2000, spent $1000 on advertising, $600 on attendants, $400 on printing tickets and $2000 on agents to sell the 1000 tickets @ $30 each. The concert was sold out and the rock group donated $10 000 to the university scholarship fund.

What was the contribution to the GNP of the rock concert?

A. $6000, the costs of putting on the rock concert
B. $16 000, the costs of putting on the rock concert and the donation
C. $24 000, total receipts minus the costs; the donation being a gift
D. $30 000, the total sales revenue of the tickets

Answer 49

The correct answer is D. The contribution to GNP can be calculated – expenditure approach, factor income approach and the output approach. In this example we have only selected expenditures and only selected incomes paid, thus A and B are incorrect. What we do have is total output value of $30 000, i.e. number of tickets times price; this is the contribution to GNP. Costs should not be deducted as this would reduce the value of total output. Thus C is incorrect.

Question 50

The following items would appear in the GNP accounts when calculated using the factor income approach

I. Exports minus imports
II. Gross private domestic investment
III. Consumption expenditure

Which of the following is correct?
A. I only
B. II only
C. I, II and III
D. Not I, not II, not III

Answer 50

The correct answer is D. Calculating GNP using the expenditure approach the categories are C (consumption expenditure), I (gross private domestic investment expenditure), G (government purchase of goods and services) and X − Z (exports minus imports), i.e. GNP C + I + G + X − Z. The factor income approach requires data on payments to resource owners for the use of their resources in the production process. None appear in I, II or III – only expenditures.

Question 51

If in a given time period households consumed more goods and services than firms produced

I. firms would experience a decrease in their desired level of inventories
II. the economy would be in disequilibrium

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 51

The correct answer is C.

Equation 1: National income (Y) ≡ C + S

Equation 2: National output (Y) ≡ C + I

Initially let equation (1) and (2) be

100 = 80 + 20

i.e. C produced = C consumed = 80 and S = 20 and I = 20, the system is in equilibrium.

New 1: Now 100 = 90 + 10

New 2: 100 = 80 + 20

The system is in disequilibrium, I ≠ S.

Thus II is correct.

To satisfy the demand for C of 90, firms will sell all they produce in this time period, i.e. 80 plus 10 from inventories, i.e. goods produced in previous periods. But this means inventories will be below desired levels; thus I is correct.

Question 52

The short-run theory of income distribution is the same as

I. the short-run theory of output determination
II. the short-run theory of employment determination

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 52

The correct answer is C. In the short-run it is assumed that the stock of technical knowledge is fixed and the stock of capital is fixed; as a consequence the productivity of labour cannot be altered and an increase in output therefore must be caused by or accompanied by an increase in labour inputs. Aggregate economic activity can be measured in two ways i.e. by measuring total output and by measuring total income. By definition they must be equal. Thus I is correct. Therefore since an increase in output, which is synonymous with an increase in income, must be accompanied by an increase in labour input II must be correct.

Question 53

In the two sector model of the economy households perform more than one function.

Households

I. buy goods and services to satisfy their wants
II. supply resources to firms
III. produce goods and services for markets

Which of the following is correct?
A. I only
B. I and II only
C. II only
D. I, II and III

Answer 53

The correct answer is B. The two sector model consists of two groups of decision makers. They are households which buy goods and services from firms and firms which produce and supply goods and services to households. All resources in the simple model are owned by households which as well as buying goods and services from firms supply resources to these firms. Thus I and II are correct. Only firms produce goods and services; thus III is incorrect.

Question 54

Which of the following is correct?

In calculating GNP the great advantage of the value added approach is that it eliminates the problem of

A. depreciation
B. intermediate goods
C. interest
D. gross profits

Answer 54

The correct answer is B. i.e. the sum of the quantity of each final good and service produced multiplied by its selling price. If any intermediate good were included double counting would occur, e.g. if the value of the steel which makes an automobile were included separately as well as the value of the automobile. The value added by a firm is the value of the output of the firm minus the value of the inputs used in the production process. Thus by summing only values added intermediate goods are eliminated. Depreciation, gross profits and interest all appear in the factor income approach.

Question 55

Consider the two identities
If the amount of consumer goods produced in some given time period equals the amount consumed then in that time period

I. planned saving will equal planned investment
II. change in inventories will be zero

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 55

The correct answer is C. In identity (1) the flow of goods and services consists of consumption goods used to satisfy immediate wants and investment goods consisting of new capital goods and/or inventories. In identity (2) income not used for consumption goods is, by definition, savings. If the amount of consumer goods produced exactly equals the amount bought then the level of inventories must remain unchanged. Thus II is correct. But that state implies also that the amount of investment which business intended will be the amount that actually occurs as will the amount of savings households planned. Thus I is correct.

Question 56

Which of the following is correct?

A. Savings and investment are injections into the circular flow of income

B. Savings and investment are withdrawals from the circular flow of income

C. Savings are withdrawals from and investment an injection into the circular flow of income

D. Savings are injections into and investment a withdrawal from the circular flow of income

Answer 56

The correct answer is C. Savings does not create a demand for goods and services which gives rise to income and employment as consumption does and is therefore a withdrawal from the circular flow. Investment on the other hand does create income and employment and is, therefore, an injection into the circular flow.

Question 57

If in year t + 1 the capital stock is greater than it was in year t then in year t

I. net investment (NI) was positive
II. gross investment (GI) exceeded replacement investment (RI)
III. gross national product (GNP) increased

Which of the following is correct?

A. I only
B. II only
C. I and II only
D. I, II and III

Answer 57

The correct answer is C. GI ≡ RI + NI For the capital stock to grow new capital goods had to be produced, i.e. NI had to have been positive but, in addition, GI would have to have exceeded RI since had GI only equalled RI the capital stock would have remained constant. Thus I and II are correct. Assuming other factors of production such as labour did not decrease potential output would have increased but there is no guarantee that actual output (GNP) increased. Thus III is incorrect.

Question 58

If households consumed all of their income continuously which of the following would occur?

A. The withdrawals from the circular flow would decline steadily

B. The system would be in continuous disequilibrium

C. The capital stock would decline

D. Consumption of goods and services would exceed national income

Answer 58

The correct answer is C. If all factor income were used to consume goods and services consumption of goods and services would equal national income, savings by households would be zero and investment expenditure by firms would be zero. There would be no withdrawals from the circular flow, no injections and the system would be in equilibrium. Thus A, B and D are incorrect. Because investment expenditure would be zero there would be no replacement investment and the capital stock would decline.

Question 59

Items which would appear directly in the GNP accounts are

I. my purchase of 2kg of potatoes to make potato soup for my family’s dinner
II. my favourite restaurant’s purchases of 20kg of potatoes to make potato soup – a speciality of the restaurant
III. farmer Bill’s purchase of 200kg of potatoes as seed for next year’s crop

Which of the following is correct?
A. I only
B. I and II only
C. I, II and III
D. Not I, not II, not III

Answer 59

The correct answer is A. Only the purchase of final goods and services enter the GNP accounts directly. While my potatoes are for soup they are not an intermediate product because I am not a firm selling soup – the potatoes are treated as a final good. Thus I is correct. For the restaurant however the potatoes are intermediate goods; the sale of soup will enter the GNP accounts; to include the potatoes also would be double counting. Thus II is incorrect. In the output approach the seed potatoes plus other inputs would ultimately yield a crop of potatoes which would be included as agricultural output; the seed potatoes are intermediate goods. Thus III is incorrect.

Question 60

Firms pay resource owners for the use of their resources in the production process; they pay wages and salaries for the use of labour services, rent for use of land and some capital goods and interest and dividends for the use of funds to buy land/capital goods. The source of these payments is firms’ sales receipts.

When all these payments have been made, what is the residual called?

A. Statistical discrepancy
B. Gross profits
C. Primary factors
D. Indirect taxes

Answer 60

The correct answer is B. This is a simple definitional question. The return to the owners of firms – the entrepreneurs/risk takers is total receipts from sales minus the sum of all factor input payments and is called gross profit.

Question 61

A computer glitch in constructing national income statistics added together

1. consumption expenditure
2. compensation of employees
3. depreciation
4. firms’ profits
5. gross private investment expenditure
6. government purchase of goods and services
7. indirect taxes − subsidies
8. interest income
9. net exports (exports − imports)
10. rental income
11. self employment income

By how much did the total overstate GNP?

A. 100%
B. It is impossible to say because major expenditure items were not included
C. It is impossible to say because major factor income items were not included
D. It is impossible to say because the outputs of the industry/services categories are missing

Answer 61

The correct answer is A. Items 1, 5, 6 and 9 (C, I, G, X − Z) when added together produce GNP using the expenditure approach. Items 2, 3, 4, 7, 8, 10 and 11 when added together produce GNP using the factor income approach. Thus by summing items 1 through to 11 the resultant sum was twice GNP. No items were missing from either the expenditure or factor incomes approach; therefore B and C are wrong. The items in the output approach are not required to calculate GNP if data from the expenditure or factor incomes approach are available.