National Income

Question 1

Tell me about the simple model of the circular flow of income

Answer 1

Imagine the economy as a simple model where there are just households and firms. The households own all the factors of production- land, labour, capital and enterprise- and the firms are the producing units. Money moves from households to firms when they buy goods and services; and money moves back to households as payment for the use of factors of production in the form of rent, wages, interest and profit. In this simple model, known as the circular flow of income, money circulates from households to firms and back again, and the more that households spend and the more that firms produce, the higher the levels of income. It does not matter which way you look at it, the income and output in an economy should always be the same, and they are measured by gross domestic product.

Question 2

In the circular flow of income, what two things should be the same

Answer 2

The income and output in an economy should always be the same. They are measured by gross domestic product.

Question 3

Make sure to look at a diagram of the circular flow of income on page 33 of theme 2 book

Answer 3

O to the K

Question 4

What is wealth

Answer 4

Wealth is the sum of all assets in an economy. It is, therefore, a stock concept.

Question 5

What is income

Answer 5

Refers to the amount of income earned during a period of time. Therefore, in contrast to wealth, it is a flow concept.

Question 6

Define wealth

Answer 6

A stock concept which refers to the total value of assets in an economy at a given moment in time.

Question 7

Define income

Answer 7

A flow concept which refers to the value of income earned over a period of time.

Question 8

Explain to me what the wealth effect is

Answer 8

In the UK, most wealth is held in the form of housing (almost 60%); the other major forms of wealth are stocks and shares and capital assets. This means that wealth does not have a direct impact on the circular flow of income, but changes in wealth have an effect on incomes and spending (the wealth effect)

For example, if you live in a property that increases in value, you might feel more confident about spending in the economy and your increased spending will then become part of the circular flow of income. Moreover, if houses become more expensive, people may go to their mortgage providers and request mortgage equity release, i.e. take out a loan based on the increased value of their homes. When the loan is spent, the circular flow increases. By contrast, if capital markets take a downturn in the USA, people living on pensions in the uk might find that their incomes fall because dividends on pension funds are often based on capital gains of shares.

Question 9

Where is wealth held in the UK

Answer 9

In the UK, most wealth is held in the form of housing (almost 60%); the other major forms of wealth are stocks and shares and capital assets.

Question 10

Define the wealth effect

Answer 10

The effect on incomes or spending when asset values change.

Question 11

What are the 3 injections into the circular flow of income:

Answer 11

investment (an increase in capital stock), government spending and exports. These all increase the circular flow and a change in any will be magnified by the multiplier.

I + G + X

Question 12

What are the three withdrawals (leakages) from the circular flow of income:

Answer 12

Savings, tax and imports.

If people decide to save more of their incomes, the economy slows down because their is less money in the circular flow. Similarly, if the government increases taxes and does not spend the money, or if people spend more on imports, the economy will slow down as money leaves the circular flow. These three leakages effectively determine the size of the multiplier.

Question 13

Define injections

Answer 13

Flows into the circular flow of income comprising investment (I), government spending (G) and exports (X)

Question 14

Define withdrawals

Answer 14

Flows out of the circular flow of income comprising savings (S), tax (T) and imports (M)

Question 15

If all injections equal all the leakages what happens?

Answer 15

The economy will be in equilibrium.

Question 16

If injections are greater than leakages, the economy will…

Answer 16

Grow

Question 17

If leakages are greater than injections the economy will…

Answer 17

Contract

Question 18

What does the circular flow of income diagram look like

Answer 18

Households at the top and firms below, areas going to households and from firms both ways. An arrow from households to firms is factors of production. An arrow from firms to households is goods and services.

Arrows pointing to the circle as I, G and M (factor incomes) and arrows pointing outwards as S, T and M (spending on goods and services)

Question 19

When AD meets AS there is an…

Answer 19

Equilibrium point, which determines the price level and real GDP of a country. An equilibrium is a balancing point where there is no tendency for price level or real output to change.

Question 20

What happens to the equilibrium when there is a shift in AD or AS

Answer 20

There is a movement away from the original equilibrium to form a new equilibrium.

Question 21

How does a new equilibrium form if price level was higher than the new equilibrium (or point at which the new AD and AS cross)

Answer 21

There would be a tendency for the price level to fall because aggregate supply would be greater than aggregate demand and there would be a surplus of goods and services.

Question 22

If the price level was lower than the new equilibrium what would happen..

Answer 22

There would be shortages of goods and services and the price level would start to rise in order to make sure that everyone could get what they were prepared to pay for.

Question 23

If there was a worldwide recession and a fall in AD occurred, the the price level would be likely to…

Answer 23

Fall.

Question 24

What’s the multiplier ratio

Answer 24

The multiplier ratio is the ratio of a change in equilibrium real income (GDP) to the autonomous change (the injection) that brought it about.

In other words, it is the number of times a change in GDP exceeds the change in net injections and withdrawals change.

For example, if there is a £10 billion increase in export values, the inward flow of money to the UK will be re-spent within the UK. When the money is spent, it becomes other people’s incomes. These incomes will be re-spent and so on. Consequently, if the final increase in GDP is £20 billion then the value of the multiplier would be 2.

Question 25

What’s the most important factor in determining the size of the multiplier

Answer 25

The size of the withdrawals from the circular flow, I.e what proportion of the additional income is saved by households, what proportion is spent on imported goods and what proportion is paid to the government in the form of taxation.

Question 26

The multiplier has what symbol

Answer 26

K

Question 27

What is the multiplier inversely proportional to

Answer 27

The marginal propensity to withdraw (MPW)

K = 1/MPW

Question 28

What is the MPW

Answer 28

Marginal propensity to withdraw (MPW) is the proportion of one unit of additional national income which is withdrawn from the circular flow, or the sum of the MPS, MPT and MPM

Question 29

What is the MPW equal to

Answer 29

The marginal propensity to save (MPT) + marginal propensity to tax (MPT) + the marginal propensity to import (MPM)

MPS + MPT + MPM

Therefore, the formula for the multiplier can also be written as

K= 1/MPS+MPT+MPM

Question 30

Define the marginal propensity to withdraw

Answer 30

(MPW) it’s a measure of how much of any extra pound earned is saved, taxed or spent on imports.

Question 31

Tell me a formula for the multiplier involving the MPC

Answer 31

The MPC = marginal propensity to consume. If you add together the MPC and MPW you get 1, I.e the total amount. Therefore if MPC + MPW = 1, a rearrangement of the formula gives the value of MPW as (1-MPC)

So,

K = 1/1-MPC

Question 32

Define marginal propensity to consume (MPC)

Answer 32

A measure of how much of any extra pound earned is spent within the economy.

Question 33

Tell me the 3 formulas for calculating the multiplier

Answer 33

K = 1/MPW

K= 1/MPS + MPT + MPM

K= 1/1-MPC

Question 34

Tell me what the importance of the multiplier is

Answer 34

If there is any change in spending in an economy, the final impact on incomes (GDP) will be greater than the initial injection. The greater the leakages, the smaller the multiplier. The formula is based on how much of any extra pound earned is re spent within the economy, I.e the marginal propensity to consume (MPC).

Question 35

What’s the size of the multiplier in the uk

Answer 35

It’s approximately 1.4 in the UK, but in developing countries it is often higher, which partly explains their higher growth rates.

Question 36

If the multiplier is larger, what happens to AD

Answer 36

The larger the value of the multiplier, the greater the shift in AD. For example if the multiplier is 1.1 in Japan a 100 trillion Yen injection into the economy by the Japanese government will have a 110 trillion positive impact on AD. If the multiplier was 2.0 the effect is 200 trillion yen.

This can both be positive and a negative direction. So an increase in leakages, for example because imports rise, will have a larger negative impact on AD depending on the size of the multiplier.

Question 37

Income is a ____ concept?

Answer 37

Flow concept.

Income (eg. Export income) is a flow concept

Question 38

Wealth is a ____ concept

Answer 38

Wealth (eg capital assets) is a stock concept

Question 39

What was the value of wealth in the UK economy in 2018

Answer 39

Over £10 trillion, five times the GDP of the economy.

Question 40

In 2018, how was the UKs wealth held

Answer 40

Just over half of the UKs wealth was held in the form of land. The rest in pension funds, life insurance funds, capital assets and shares.

Question 41

Changes in injections have what effect on the total level of spending in the economy

Answer 41

A multiplier effect. An increase in injections has a proportionately larger effect on GDP.

Question 42

Changes in leakages affect the size of the….

Answer 42

Multiplier. The larger the leakages, the smaller the value of the multiplier.

Question 43

Is consumption an injection into the circular flow

Answer 43

No, the injections are investment, government spending and exports.