Section 9 - The Circular Flow of Income

Question 1

The Circular Flow of Income

Answer 1

>Income flows between firms and households.
>Firms produce goods and services, and all of these goods and services make up the national output.
>The households in a country provide the labour, land and capital that firms use to produce the national output. The money paid to households by firms for these factors of production is the national income.
>Households spend the money they get from the national income on the goods and services (outputs) that firms create - the value of this spending is the national expenditure.
>So all this creates a circular flow of income.

Question 2

Circular flow of income formula

Answer 2

>National output = national income = national expenditure.
>At full employment, national income, national output and national expenditure are all equal to the ‘full-employment income’.

Question 3

What are the 2 types of flow in circular flows of income?

Answer 3

>Physical flows of ‘real things’ - i.e. goods, services, labour, land and capital. (Straight arrows).
>A monetary flow - i.e. the money that pays for the ‘physical thing’. (Curved arrows).

Question 4

Circular Flow Diagram

Answer 4

Question 5

Injections and Withdrawals

Answer 5

>The circular flow suggests that as long as households keep spending what they earn, and firms keep using their revenues to produce more goods using the same inputs, then national output (and national income) won’t change.
>However, an economy’s circular flow of income is affected by injections and withdrawals (or leakages).
>Injections into the circular flow of income come in the form of exports, investment and government sending - these go directly to firms.
>Withdrawals come in the form of imports, savings and taxes - these withdrawals can be made by households or firms.
>Injections and withdrawals can be shown in a circular flow.

Question 6

Injections - examples

Answer 6

>Exports, investment and government spending.

Question 7

Withdrawals - examples

Answer 7

>Imports, savings and taxes.

Question 8

Balancing withdrawals and injections.

Answer 8

>If injections and withdrawals are equal, then the economy is in equilibrium.
>If injections into the circular flow are greater than withdrawals, this means that expenditure is greater than output - so firms will increase output. As a result national output, income and expenditure will all increase.
>If withdrawals from the circular flow are greater than injections, this means that output is greater than expenditure - so firms will reduce output. As a result national output, income and expenditure will decrease.

Question 9

What do injections have?

Answer 9

>Injections have a multiplier effect on the circular flow.
>When an injection is made into the circular flow, the actual change in the national income is greater than the initial injection - this is called the multiplier effect.
>The size of the multiplier effect depends on the rate at which money leaks from the circular flow - e.g. the bigger the leakages, the quicker the money will leave the circular flow and the smaller the multiplier effect will be.
>So, if lots of money is being spent on imports (or used as savings or tax), then the multiplier effect will actually be quite small because the injection will quickly leak out out of the circular flow.

Question 10

Wealth vs Income

Answer 10

>Wealth is different to income.
>Wealth is the total value of all the assets owned by individuals or firms in an economy.
>Assets can include actual money, e.g. savings, and physical items, e.g. houses or cars.

Question 11

Wealth

Answer 11

>Unlike income, which is a flow of money, wealth is a stock concept - you can think of it as a stockpile of resources.
>These resources aren’t currently being used in the circular flow of income, but they could be at some point.

Question 12

Income and wealth

Answer 12

>Although income and wealth are different things there’s a correlation between them.
>For example, it’s likely that an individual with a high income will also have high wealth, because they’ll be able to purchase more expensive assets and have more money to save.

Question 13

Aggregate Demand

Answer 13

>AD is the total spending on goods and services.
>AD is the total demand, or the total spending, in an economy over a given period of time.
>So AD is made up of all the components that contribute to spending/demand in an economy.
>Formula: C + I + G + (X-M).

Question 14

Consumption

Answer 14

>Consumption (a.k. consumer spending or consumer expenditure) is the total amount spent by households on goods and services. It doesn’t include spending by firms.
>An increase in consumption will mean an increase in AD.
>Consumption is the largest component of AD - it makes up about 65% of AD in the UK.
>This means changes in the level of consumption will tend to have a big impact on AD.
>Savings are made instead of consumption.

Question 15

Savings and consumption

Answer 15

>Income can be consumed or saved.
>When consumption ishigh, saving tends to be low, and vice versa.

Question 16

Main factors affecting consumption and saving

Answer 16

1. Income.
2. Interest rates.
3. Consumer confidence.
4. Wealth effects.
5. Taxes.
6. Unemployment.

Question 17

Factors affecting consumption and saving - income.

Answer 17

>Generally, as disposable income increases, consumption will rise.
>The rate at which consumption rises is usually lower than the rate at which income increase because households tend to save more as well.

Question 18

Factors affecting consumption and saving - interest rates.

Answer 18

>Higher interest rates lead to less consumer spending.
>Consumers save more to take advantage of the higher rates and they’re less likely to borrow money to buy things on credit because it;s more expensive.
>Consumers may also have less money to spend if interest rates on existing loans and mortgages increase.

Question 19

Factors affecting consumption and saving - consumer confidence

Answer 19

>When consumers feel more confident about the economy and their own financial situation, they spend more and save less.
>Confidence is affected by a number of factors.
>E.g. in a recession consumers are usually reluctant to spend because their confidence in the economy is low - they might, for example, be worried about losing their jobs.
>This reluctance can continue even after a recession.

Question 20

Factors affecting consumption and saving - wealth effects

Answer 20

>A rise in household wealth , e.g. due to a rise in share prices or house prices, will often lead to a rise in consumer spending and a reduction in saving.
>This is because of consumer confidence - if house rices rise faster than inflation, house owners will feel more confident in their own finances.

Question 21

Factors affecting consumption and saving - taxes

Answer 21

>Direct tax increases lead to a fall in consumers’ disposable income, so they spend less.
>Indirect tax increases, e.g. increase in VAT, increase the cost of spending, so consumers tend to reduce their consumption.
>A reduction in direct or indirect taxes will lead to an increase in consumer spending.

Question 22

Factors affecting consumption and saving - unemployment

Answer 22

>When unemployment rises, consumers tend to spend less and save more.
>People still in employment will tend to replace spending with saving, as they become more worried about losing their jobs.
>A fall in unemployment means more people have money to spend, and consumers are less worried about losing their jobs, so consumer spending increases.

Question 23

Saving vs Investment

Answer 23

>It’s important to realise that investment and saving are different things.
>Savings tend to be made by households, whereas investments tend to be made by firms.
>E.g. savings made by a household might be money put into a savings bank account each month.
>E.g. an investment made by a firm could be money paid to build a new office.

Question 24

Investment - definition

Answer 24

>Investment is money spent by firms on assets which they’ll use to produce goods or services - this includes things such as machinery, computers and offices.

Question 25

What are the 2 types of investment?

Answer 25

1. Gross
2. Net

Question 26

Gross investment

Answer 26

>Gross investment includes all investment spending.

Question 27

Net investment

Answer 27

>Net investment only includes investment that increases productive capacity.
>E.g. if a firm has 3 old trucks and replaces these with 5 new trucks then gross investment is 5 trucks but net investment is 2 trucks.

Question 28

Why do firms invest?

Answer 28

>Firms invest with the intention of making profit in the future.
>Investment makes up about 15% of AD in the UK.

Question 29

What factors affect investment?

Answer 29

1. Risk
2. Government incentives and regulation
3. Interest rates and access to credit
4. Technical advances
5. Business confidence and ‘animal spirits’.
6. Investment also depends on how quickly national income is changing - this leads to an effect called the accelerator process.

Question 30

Factors that affect investment - risk

Answer 30

>The level of risk involved will affect the amount of investment by firms.
>If there’s a high risk that a firm won’t benefit from its investment then it’s unlikely the firm will invest.
>For example,when there’s economic instability, less investment will be made.

Question 31

Factors that affect investment - government incentives and regulation

Answer 31

>Government incentives such as subsidies or reductions in tax can affect the level of investment. E.g. a reduction in corporation tax might encourage firms to invest, because they’ll have more funds available to do so.
>A relaxing of government regulations might reduce a firm’s costs and make it more likely to invest.

Question 32

Factors that affect investment - interest rates and access to credit

Answer 32

>Firms often borrow the money they want to invest. This means that when interest rates are high or firms are unable to access credit, investment tends to be lower.
>High interest rates would reduce how profitable an investment would be (since interest charges on loans will be higher).
>High interest rates will also mean there’s a greater opportunity cost of investing existing funds instead of putting them into a bank account with a high interest rate.

Question 33

Factors that affect investment - technical advances

Answer 33

>Firms need to invest in new technology to stay competitive,
>Investment will rise when significant technological advances are made.

Question 34

Factors that affect investment - business confidence and ‘animal spirits’

Answer 34

>The more confident a business is in its ability to make profits (because demand for exports is high, e.g.) the more money it is likely to invest.
>But ‘business confidence’ depends partly on the general optimism or pessimism of the company’s managers.
>Keynes recognised that not all investment decisions are based purely on reason and rational thinking, and that human emotion, intuition and ‘gut instinct’ are also important factors.
>He called these factors ‘animal spirit’.

Question 35

Factors that make up the animal spirit

Answer 35

>Human emotion, intuition and ‘gut instinct’.

Question 36

Meaning of ‘being able to access credit’

Answer 36

>being able to borrow money

Question 37

Government spending - definition and more

Answer 37

>The government spending component of AD is the money spent by the government on public goods and services, e.g. education, health care, defence etc.
>Only money that directly contributes to the output of the economy is included - this means that transfers of money such as benefits or pensions are not included.
>Government spending is quite a large component of AD, so changes in government spending can have a big influence on AD.

Question 38

Government spending - budget

Answer 38

>A government budget outlines a government’s planned spending and revenue for the next year.
>Governments will usually have either a budget deficit or surplus.
>An imbalance in the budget will affect the circular flow of income - a budget surplus will indicate an overall withdrawal from it and a budget deficit an overall injection.

Question 39

Budget deficit

Answer 39

Where government spending is greater than its revenue.

Question 40

Budget surplus

Answer 40

Where government spending is less than its revenue.

Question 41

Government spending and influence on AD

Answer 41

>Governments use fiscal policy to alter their spending and taxation to influence AD.
>If AD is low and economic growth is slow, or even negative, then a government may try to overspend (causing a budget deficit) in order to increase AD and boost economic growth.
>If AD is high and the economy is experiencing a boom, a government might increase taxes and spend less (causing a budget surplus) to try to reduce AD and slow down economic growth.

Question 42

Imbalance in the budget - government spending

Answer 42

>An imbalance is fine in the short-run, but in the long run governments will try to balance out any surpluses and deficits.
>A long-term surplus might mean the government is harming economic growth by choosing not to spend, or by keeping taxes too high.
>A long-term deficit is likely to mean a country has a large national deficit.
>Sometimes governments will balance the budget so that government spending will be equal to revenue. This should have little effect on AD.

Question 43

Exports - definiton

Answer 43

>Exports are goods or services that are produced in one country, then sold in another.

Question 44

Imports - definiton

Answer 44

>Imports are the goods and serves that are brought into a country after being produced elsewhere.

Question 45

Exports and imports

Answer 45

>An export in one country is always an import to another.
>Exports are an inflow of money to a country and imports are an outflow.
>So exports are injections and imports withfrawals to the CF.

Question 46

Net exports

Answer 46

>Exports minus imports (X-M) make up the net exports component of AD.
>If the amount spent on imports exceeds the amount received from exports (like in UK), net exports will be a negative number.
>Net exports tend to make up a small % of AD so changes have a minor impact on AD.

Question 47

What factors will affect the net exports component of AD?

Answer 47

1. Exchange rate
2. Changes in the state of the world economy
3. Degree of protectionism
4. Non-price factors.

Question 48

Factors that affect net exports - exchange rate

Answer 48

>In the long run - if the value of the currency increases, imports become relatively cheaper and exports relatively more expensive for foreigners.
>As a result, demand for imports rises and demand for exports falls.
>So a strong currency (i.e. a currency with a high value) will worsen net exports in the long run ad reduce AD, but a weak currency will have opposite effect and improve net exports.
>In the short run - demand for imports and exports tends to be quite price inelastic.
>For example, some goods don’t have close substitutes, e.g. oil, while others might have substitutes, but there’s a time lag before countries will switch to them - so in the short run demand won’t change much.
>This means that initially when the value of a currency increases, net exports will actually improve because hte overall value of exports increases and the overall value of imports decreases.

Question 49

Factors that affect net exports - changes in the state of the world economy

Answer 49

>The higher a country’s real income, the more it tends to imports. So net exports fall as real income rises.
>The state of the world economy also affects exports and imports.
>For example, the USA exports lots of goods to Canada. If Canada goes through a period of low growth then exports from the USA to Canada will decrease, Assuming imports are unaffected, this means a worsening in the USA’S net exports.

Question 50

Factors that affect net exports - degree of protectionism

Answer 50

>In the short run, tariffs and quotas can increase net exports by reducing imports.
>However, industries that are protected from international competition have few incentives to become more efficient, so will often export less in the long run.
>Also in the long run, other countries may retaliate by introducing their own tariffs and quotas.

Question 51

Factors that affect net exports - non-price factors

Answer 51

>These include things such as the quality of goods.
>For example, advancements in technology in a country that lead to the production of higher quality goods would be likely to cause an increase in exports from that country, because people are willing to pay more something if it’s really good.
>This would mean an improvement in net exports.

Question 52

The Aggregate Demand Curve

Answer 52

>The AD curve uses different axes to the normal demand curve.
>The AD curve slopes downwards - the lower the price level, the more output is demanded.
>Lower prices mean consumers can buy more goods/services with their money.
>A change in price level will cause a movement along the AD curve - for example, if the price level rose from P to P to P1, the total AD would fall from Y to Y1.
>A rise in price level will cause output to fall.

Question 53

AD Curve:

Answer 53

Question 54

Axis of an AD curve

Answer 54

>Along the x-axis is national output.
>Along the y-axis is price level.
>The price level represents the average level of prices in an economy - in the UK this price level is likely to be the Consumer Price Index.

Question 55

Why does a rise in price level cause output to fall?

Answer 55

1. Domestic consumption will be reduced - things become more expensive, so people can purchase fewer goods and services.
2. The demand for exports will be reduced - domestically produced products become less competitive.
3. The demand for imports will increase - if prices haven’t risen abroad, imports will become cheaper in comparison.

Question 56

What causes a shift of the AD curve?

Answer 56

>An increase or decrease in AD.

Question 57

AD curve - shift to the right

Answer 57

>The AD curve will shift to the right if there’s a rise in consumption, investment, government spending or net exports that hasn’t been caused by a change in the price level.

Question 58

Example of AD shifting to the right

Answer 58

>A reduction in income tax will cause an increase in consumers’ disposable income. This tends to lead to an increase in consumption so there will be an increase in AD and a shift of the AD curve to the right.
>If the government changes its fiscal policy and decides to increase its spending above any increase in its revenue, then this is an injection into the CF. It will cause an increase in AD and shift to the right.
>A weak currency will make exports cheaper and imports more expensive. This will lead to a rise in net exports, so there will be an increase in AD and shift to the right.

Question 59

What does an outward shift of the AD curve mean?

Answer 59

>The outwards shift of the curve means that at a given price level, more output can be produced - but also, a given amount of output will have a higher price level.
>For example, if there’s an increase in AD at price level P there’s an increase in output from Y to Y1 and at output Y the price level increases from P to P1.
>Labour is a derived demand - an increase in AD means output increases, so the demand for labour increases.
>More jobs are created so that the extra output can be produced, and there will be an increase in employment levels.

Question 60

AD curve - shift to the left

Answer 60

>The AD curve will shift to the left if there’s a fall in consumption, investment, government spending or net exports that hasn’t been caused by a change in price level.

Question 61

Example of AD curve inward shift

Answer 61

>A rise in interest rates will lead to a reduction in consumer sending because people will choose to save more.
>Higher interest rates also lead to a reduction in investment because borrowing the money to invest becomes more expensive.
>Both these factors lead to a reduction in AD, and a shift left.
>A strong currency will make exports more expensive and imports cheaper, so there will be a fall in net exports.
>This will lead to a reduction in AD and a shift to the left.

Question 62

What does an inwards shift of the AD curve mean?

Answer 62

>The inward shift of the curve means that at a given price level, less output can be produced - but also, a a given amount of output will have a lower price level.
>There will also be a decrease in employment levels.

Question 63

Macroeconomic Equilibrium Diagram:

Answer 63

Question 64

What does the multiplier effect lead to?

Answer 64

>The multiplier effect leads to a larger increase in AD.

Question 65

Multiplier effect

Answer 65

>When there’s an injection into the economy (e.g. as a result of increased government spending), the AD curve will shift to the right
>However, when money is injected into the CF, the value of the initial injection is multiplied - this is the multiplier effect.
>One person’s expenditure becomes someone else’s income, so the money goes round the CF multiple times until it’s all leaked out.
>The effect is that the AD curve shifts even further to the right - and the bigger the multiplier, the greater the shift.

Question 66

Example of multiplier effect and AD

Answer 66

>If a government injects money into health care, the money might be used for wages.
>Some of this money would be spent by consumers - increasing consumption.
>This would create a second increase in AD, and the cycle will continue until all the money from the initial injection has leaked out.

Question 67

What does the size of the multiplier depend on?

Answer 67

>The overall size of the multiplier will depend on the size of the leakages from the CF, but it’s very difficult to measure in practice.
>This is partly because there are time lags and the multiplier effect of government spending can take years to show up fully in the economy.
>Measuring the size of the multiplier is also difficult because like everything else in the economy, it’s changing all the time.
>This makes it very difficult for the government to accurately control AD.

Question 68

Accelerator Effect and the impilcations:

Answer 68

• The accelerator effect happens when an increase in national income (GDP) results in a proportionately larger rise in capital investment spending.
• In other words, we often see a surge in capital spending by businesses when an economy is growing quite strongly.
• Implications:
• Investment tends to be more volatile than economic growth
• The rate of economic growth stays the same. Investment levels will also stay the same
• Investment spending can fall even when GDP is rising. This is because if there is a fall in the rate of economic growth firms may invest less.
• If GDP falls, investment spending can fall very significantly.
• Accelerator Coefficient. This is the level of induced investment as a proportion of a rise in National income accelerator coefficient = Investment/change in income.

Question 69

Average propensity

Answer 69

>Average propensity to consume or save shows what happens to incomes.
>Spending and saving are both really important in an economy, and they’re basically opposite processes.
>Money that’s spent continues to circulate round the economy, while money that’s saved is withdrawn from the CF.
>The ‘average propensity’ formulas tell you the proportion of the total national income that’s either spent or saved.

Question 70

Average propensity to consume - formula

Answer 70

>APC = consumption/total income.
>C/Y.

Question 71

Average propensity to save - formula

Answer 71

>APS = amount saved/total income.
>S/Y.

Question 72

Marginal propensity

Answer 72

>In Economics, ‘marginal propensity’ is often more important than ‘average propensity’.
>The marginal propensity to consume (MPC) is the proportion of any extra income that’s spent on the consumption of goods and services.
>Similarly, the marginal propensity to save (MPS) is the proportion of extra income that’s saved.

Question 73

MPC - formula

Answer 73

>MPC = change in consumption/change in income.

Question 74

MPS - formula

Answer 74

>MPS = change in saving/change in income.

Question 75

Why are MPC and MPS important?

Answer 75

>MPC and MPS are important, since the size of the multiplier will depend on how much of an injection of money into the CF is spent by those who receive it, and how much is saved.
>Money that’s saved does not contribute to another person’s income.
>This means that the more likely people are to spend their money, the greater the multiplier effect.
>So if the MPC is low, the multiplier effect will be small, because any increase in income will only lead to a small increase in consumption. The rest of the increase in income will be saved.

Question 76

Trends of MPC

Answer 76

>Generally, people with lower incomes tend to have higher MPCs.
>The MPC also tends to be higher in less developed countries, so the multiplier will be bigger.

Question 77

Formula for calculating the multiplier

Answer 77

>1/(1-MPC).

Question 78

Aggregate supply - definition

Answer 78

>AS is the total output produced in an economy at a given price level over a given period of time.
>There are 2 types:
-SRAS.
-LRAS.

Question 79

Short run aggregate supply

Answer 79

>Short run aggregate supply (SRAS) curves slope up from left to right.
>They show that with an increase in the price level, there’s an increase in the amount of output firms are willing to supply.

Question 80

SRAS and PES.

Answer 80

>If SRAS is price inelastic, the SRAS curve slopes steeply upwards.
>If SRAS is price elastic, the SRAS curve would be less steep.

Question 81

Long run aggregate supply

Answer 81

>In the long run, it’s assumed that an economy will move towards an equilibrium where all resources are being used to full capacity (so the economy is running at its full productive potential).
>This is shown by the LRAS curve.
>The LRAS curve is vertical .
>An increase in the price level won’t cause an increase in output because the economy is running at full capacity, so it can’t create any more output.
>These are ‘classical’ or ‘neo-classical’ AS curves.

Question 82

Shifts in the SRAS curve

Answer 82

>The SRAS curve will shift if there’s a change in the costs of production.
>A reduction in the costs of production means that at the same price level, more output can be produced, so the SRAS curve will shift to the right.
>For example, a reduction in the price of oil might shift the curve outwards - so are price level P, output would increase from Y to Y1.
>Changes in things such as wage rates, the taxes firms pay, exchange rates and efficiency levels will cause shifts of the SRAS curve.
>A sudden decrease in AS (leading to a price increase) could be caused by supply-side shocks, such as natural disaster or war.

Question 83

Shift to LRAS curve - main one

Answer 83

>LRAS is determined by the factors of production - the LRAS curve will shift if there’s a change in the factors of production which affects the capacity of the economy.
>An improvement in the factors of production increases the capacity of the economy, and will shift the LRAS curve to the right. This increases output (i.e. economic growth) from Yf to Yf1 - the same price level now corresponds to a higher level of output.
>E.g. investment that leads to advances in technology and more efficient production will increase maximum output.

Question 84

Examples of improvements in the factors of production which might shift the LRAS curve to the right are…

Answer 84

1. An improvement in education and skills - better education and training should lead to more productive individuals, i.e. the output per person will increase, so maximum output is increased.
2. Demographic changes - e.g. skilled workers migrating to a country can increase the economy’s capacity.
3. A supply of new resources - new resources may mean the max output of the economy can be increased.
4. Improvements in health care - if the overall health of worker improves, they’re likely to have less time off work and retire at an older age. This means the productivity and size of the economy’s labour force increases.
5. Changes in government regulations - e.g. the removal of unnecessary rules and ‘red tape’.
6. An increase in competition - greater competition in an economy will cause inefficient firms to close and be replaced by more efficient firms - increasing an economy’s capacity.
7. Promoting enterprise - e.g. by providing economic incentives or guidance for people starting new businesses.
8. Increasing factor mobility - e.g. with training schemes to reduce occupational labour immobility.

Question 85

What would cause LRAS to shift left?

Answer 85

>A deterioration in the factors of production that reduces an economy’s capacity will cause the LRAS curve to shift to the left, e.g. if there’s a massive reduction in the supply of oil then maximum possible output will be reduced.

Question 86

Keynesian Vs Classical Diagram

Answer 86

• The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic.
• The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour e.t.c.
• Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP>
• The Keynesian view argues that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons:
• Wages are sticky downwards (labour markets don’t clear)
• Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less income and reduce their spending creating a negative knock-on effect.
• Loss of consumer confidence, leading to a fall in consumption and demand.