Theme 2 - National Income Flashcards
What is the circular flow of income?
A model that seeks to explain how the economy works and how changes in AD occur, by looking at the concept of money flows throughout he economy
What assumptions are made in the basic circular flow of income model?
- Households are spending all they factor incomes
- No trade; all domestic consumption
- No government involvement
How does the circular flow of income work?
- Households own all the wealth and resources, so provide the firms with land, labour and capital in return for rent, wages, interest and profit
- They use this money to buy goods and services produced by the firms
- Money flows in one direction and goods and services and FoPs flow in another
- In this model, there are 3 ways of measuring the level of economic activity: national output, national expenditure, and the national income
- In this model, national output = national expenditure = national income
Why is the basic circular flow of income model too simplified to represent the actual economy?
- The government needs to be added; they take money out through taxation and add money by spending. I they spend more than they take they can increase the flow of income
- Financial services can inject money through investment and take money away when consumer or producers save
- Exports add money to the flow, but imports remove money from the flow
What are injections?
Monetary additions to the economy:
- Government spending (G)
- Investment (I)
- Exports (X)
What are withdrawals/leakages?
Where money is removed from the economy:
- Taxes (T)
- Savings (S)
- Imports (M)
What is macroeconomic equilibrium?
A situation where aggregate demand equals aggregate supply at a given price level
Classical economists and macroeconomic equilibrium
- As the classical LRAS curve is perfectly inelastic, a shift in AD would not affect long run national output, it would only affect price levels
- They believe an increase in AD will lead to a positive output gap.
- When AD shifts right, the economy is in long term disequilibrium as SRAS and AD now do not intersect on the LRAS curve. The short term equilibrium is where the new AD and original SRAS meet
- There is over full employment so firms bid up wages of labour and the other factor prices. SRAS shifts left as costs of production have increased. Eventually the economy is producing the same amount, but at higher prices
- They believe that the only way to increase output is by increasing LRAS. A rise in LRAS is likely to lead to lower prices and higher output
Keynesian economists and macroeconomic equilibrium
- Keynesian economists agree that there is full employment where the LRAS is vertical, but they also believe that there can be equilibrium at less than full employment (where the curve is horizontal) because they don’t believe that a rise in unemployment rapidly leads to a fall in real wages
- They would agree that a right shift in AD where the curve is vertical is purely inflationary and would increase price and not output
- If the economy is in deep recession (horizontal) then an increase in AD only increases output and not price
- With a Keynesian curve the impact of a shift in AD strongly depends on the elasticity of the curve, and hence whether the economy is at or near full employment.
- If the economy is producing at or near full employment, then a rise in LRAS will increase output and decrease price level. However if the economy is in a deep recession, then an increase in LRAS will have no impact on prices or output
What is the multiplier effect?
The process by which a change in an injection in the circular flow of income brings about a greater change in GDP than the initial injection
What the multiplier ration?
The ratio of the final change in income to the initial change in injection
What determines the size of the multiplier?
How much of an increase in income people will spend (MPC) - the lower the leakages, the higher the MPC, the bigger the multiplier
What allows the multiplier to work?
The concept of circular flow; since one person’s spending is another’s income. The IMF have calculated that in developed countries, the multiplier tends to be around 1.5 in the long run and 1.6 for developing countries
How do you calculate MPC?
change in spending / change in income
How do you calculate the multiplier?
1 / (1-MPC) or 1/MPW
What is MPC?
Marginal propensity to consume - increase in consumption following increase in income
What is MPS?
Marginal Propensity to save - increase in savings following an increase in income
What is MPT?
marginal propensity to tax - increase in taxation following an increase in income
What is MPM?
marginal propensity to import - increase in imports following increase in income
What is MPW?
marginal propensity to withdraw - increase in leakages following an increase in income
MPW= MPS+MPT+MPM
Effects of a change in AD on multiplier
- The multiplier leads to an increase in AD higher than the original increase but for it to gave the desired effect there must be sufficient spare capacity in the economy for extra output to be produced
- If the AS is perfectly inelastic, then the only impact will be to increase price - will only affect output in the short run
- The more elastic the curve, the smaller the effect on price, but the bigger the effect on output
Evaluation of the multiplier
- Difficult to measure its exact size
- It has time lags
- Lower in developed countries
What is income?
A flow of earnings from using FoPs to generate an output of goods and services
What is wealth?
The value of a stock of assets
