Theme 2 Topic 4 Flashcards
What is the circular flow of income ?
An economic model showing the flow of goods and services, the factors of production, and their payments between households and firms within an economy.
What does the simple model show ?
The UK economy is complex and operates in a global environment.
The model is simplified for analysis.
Assumptions:
- The economy is “closed” (no foreign trade or government influence).
- There are two main groups: firms and households.
What does the circular flow of income show ?
Flow of money:
- Households (owners of factors of production) purchase goods and services from firms.
- Money flows back to households in the form of wages, rent, interest, and profit.
what does national output equal ?
national expenditure = national income
what are the 4 stages of the circular flow of income ?
1)Firms provide households with goods and services
2) Households spend their income on the goods and services produced by firms
3) Households also provide firms with factors of production: CELL
4) In order to pay for these factor services, firms pay households rent, wages, interest and profit
How does GDP influence the flow of income ?
The more households spend the more firms produce. Demand drives supply.
Income and output should always have the same value in a closed model
We measure income/output using GDP
land labour capital :
buildings, output, investment
rent, wages, interest, profit
land, labour, capital, entrepreneurship
what are the 4 assumptions that cause the model to be unrealistic ?
- Households spend all their income on goods
and services - Firms spend all their income on factors of
production - There is no government
- There is no foreign trade
what is the correlation between income and wealth ?
wealth is a stock concept.
income is a flow concept.
as income flows from the stock of assets a nation’s income and wealth are directly correlated
how is wealth a stock concept ?
assets owned (e.g. buildings, land)
human wealth (e.g. skills, education)
how is income a flow concept ?
money generated from wealth (e.g. wages, rent, interest)
income + wealth correlation :
- An increase in income boosts wealth, providing finance for investment.
- Investing in productive capacity increases the stock of physical assets, raising wealth.
- This leads to economic growth and higher future income.
- Higher future income allows further growth in wealth.
- There is an opportunity cost between consumption today and in the future.
- By investing in productive capacity, future income can be increased.
what are the 3 injections ?
- Investment (increase in capital stock)
- Government spending
- Export purchases
what are the 3 leakages ?
- Savings
- Taxation
- Import purchases
how is the flow of income link shown on the PPF curve ?
-There is a trade-off between using our income for consumption today and consumption for future generations
- If we use our income to invest in capital goods today it means that we are increasing our productive capacity
• This means that we have a greater stock of wealth
• An increase in capital goods will shift the PPF outwards
• This economic growth will lead to higher income in the future
Why do we consider injections and withdrawals ?
To take into account a more realistic role of all the participants in the circular flow.
How are injections + withdrawals shown on the circular flow of income diagram.
Injections go in
Withdrawals go out
What are injections ?
Monetary additions to the economy.
What are leakages ?
Money is removed from the economy
injection greater than leakage :
economy grows
injection less than leakage :
economy shrinks
injection in equilibrium with leakage :
national income remains the same
What is the macro economic equilibrium ?
Demand side and supply side of the economy are equal.
Everything produced by firms has been consumed by households.
No excess supply or demand.
What does the size of the AS/AD shift depend on ?
The size of the shift
The elasticity of the curve (which hasn’t been moved)
e.g. the elasticity of AS if AD has been moved.
if AS or AD shifts, equilibrium changes position.
short term :
both classical and keynesian economists agree that AD will be downward sloping and AS will be upward sloping.
Keynesian :
support economic policies that improve and manage AD.
if the economy is operating below its full potential (e.g. recession), they would focus attention on policies that stimulate the components of AD.
Keynesian graph :
there is full employment where the LRAS curve is vertical.
however, there can be equilibrium at less than full employment where the curve is horizontal.
this is because they don’t believe that a rise in unemployment rapidly leads to a fall in wages.
unemployment occurs due to a deficiency of AD.
long term AS :
- Economy is in equilibrium where AS = AD (Aggregate Supply = Aggregate Demand).
- Supports economic policies that improve LRAS (Long-Run Aggregate Supply).
- If AD increases without improving factor resources (quality/quantity), inflation occurs, which harms economic growth.
-
LRAS curve is perfectly inelastic:
- A shift in AD doesn’t affect national output in the long run.
- Only affects price levels.
- Belief: The economy will always return to full employment in the long run, so no unemployment in the long run.
increase in AD (LRAS) :
- Positive Output Gap: The economy is producing above its potential, leading to over full employment.
- SRAS shifts left: As firms compete for labor, they bid up wages, increasing costs.
- Higher wages: Firms offer higher salaries to attract the best workers, causing costs to rise.
- Result: The economy produces the same output but at higher prices, shifting SRAS left until it aligns with LRAS.
- Short-run impact: Increase in both price and output.
- Over time, prices will continue to rise as the economy moves back to long-term equilibrium.
- Output doesn’t change in the long run; to increase output, LRAS must increase.
- Changes in AD without changes in LRAS lead to inflation.
shift in LRAS to the right :
causes lower prices and a higher output.
classicists economists favour supply side policies over demand management due to this.
SRAS and AD don’t intersect so it will be closed by a shift in SRAS.
Keynesian increase in AD from AD-AD1:
shifts right.
expansion along LRAS curve.
price level increases to P1.
economy gets closer to full employment and resources are becoming more scarce.
output increases to Y1, but spare capacity of Y1-FE remains.
Keynesian increase in AD from AD1-AD2 :
if AD continues to increase without any increases in LRAS, at some point FE equilibrium will be reached, and any increases in AD above AD2 will be purely inflationary.
Keynesian AD - AD3 to AD4 (lower point on curve):
if AD is at AD3 and shifts right to AD4, price level would be unchanged as there remains spare capacity in the economy.
increases in AD can be absorbed without increases in the price level.
any policies to increase LRAS would enhance spare capacity and leave the equilibrium level of employment unchanged.
Keynesian LRAS shift right :
caused by an increase in capital efficiency.
there would be an expansion along the AD curve.
price level decreases (as available factor resources are increased and scarcity decreases).
real national output increases to Y1 and maximum productive potential increases to FE1.
this indicates economic growth.
What does the impact of a shift in AD depend on ?
the elasticity of the curve.
and whether the economy is at or near full employment
what do Keynesians argue should happen during recessions ?
the government needs to work to increase AD rather than using supply side policies.
increasing AD and AS :
•Increased AD (e.g., investment) raises demand for goods and services.
• Short-run effect:
• The economy can’t immediately meet this higher demand.
• This causes temporary disequilibrium, where demand exceeds supply and prices rise (inflation).
• Investment boosts LRAS:
• New investments (like machinery or technology) increase the economy’s capacity to produce goods.
• This shifts Long-Run Aggregate Supply (LAS) to the right, meaning the economy can produce more without facing capacity limits.
• Long-run effect:
•With increased LAS, the economy can handle higher demand without causing inflation.
The economy reaches long-run equilibrium where output increases and prices stay
stable.
The efficiency of this concept depends on the rate of return on investment (whether it affects supply or not)
what is the multiplier effect ?
occurs when an initial injection into the economy (or a circular flow of income) causes a larger final increase in the level of real national output.
this is due to an increase in AD.
one person’s spending is another person’s income
multiplier effect’s impact on AD :
targeting individuals with a high MPC can boost AD in times of low demand.
what is the multiplier ratio ?
ratio of the total change in income to the initial change in injection.
formula for multiplier :
multiplier = 1/1-MPC
if MPC = 0.9, the multiplier is 10.
1 represents 100% of the extra pound being spent.
what happens if there is a higher MPC and low leakages.
the larger the multiplier (people spend more of their income).
the government can stimulate demand more effectively by focusing on individuals who spend most of their income.
multiplier size in developing + developed countries :
developed = around 1.5
developing = around 1.6
negative multiplier :
due to withdrawals (e.g. tax hikes, reduced government spending), which causes a decline in AD and further reductions in income.
causes slower economic growth.
what is MPC ?
proportion of any change in income that is spent on consumption rather than saved. it drives consumption.
what is MPW ?
marginal propensity to withdraw.
the total increase in leakages in the economy, reducing the multiplier effect.
MPW formula :
MPW = MPS + MPT + MPM
an increase in either one reduces MPC and weakens the multiplier effect.
what is MPS ?
marginal propensity to save.
the proportion of income saved rather than consumed.
a higher MPS means there is reduced spending and lowers the multiplier.
what is MPT ?
marginal propensity to tax.
the proportion of income taxed.
higher taxes decrease disposable income, decreasing consumption and lowering the multiplier.
what is MPM ?
marginal propensity to import.
the proportion of additional income spent on imports.
higher imports decrease domestic spending and lowers the multiplier.
3 factors affecting MPC ?
- interest rates
- Taxes
- Imports
Multiplier size is sensitive to these factors.
What does the multiplier size equal ?
1/1-MPC = 1/MPW
Factors affecting MPC - interest rates
Increased rates encourage saving over spending, so MPC falls.
Factors affecting MPC - taxes
Higher taxes (MPT) decreases disposable income and consumption, decreasing MPC.
Factors affecting MPC - imports
Increased spending on imports (increased MPM) reduces domestic consumption, lowering MPC.
2 effects of the multiplier on the economy :
- Dynamic economy
- Measuring the multiplier
Dynamic economy :
The multiplier is influenced by variables such as :
Spare capacity : if it’s low, firms can’t meet higher demand, limiting the multiplier’s effect.
Unemployment : higher unemployment allows firms to expand and boost AD more effectively.
Inflation and the exchange rate : increased inflation decreases the real impact of injections. exchange rates affect trade and demand.
measuring the multiplier :
it’s difficult to measure precisely due to many changing factors.
it’s influenced by MPC, MPS, MPT, MPM.
it’s likely that those on low incomes will have a higher MPC, so AD will shift right if the government prioritises these.
targeting the multiplier :
low income groups : low income means higher MPC.
government spending : directing spending to low income groups leads to larger increases in AD and national income.
challenges and limitations of the multiplier :
uncertainty : governments can’t predict the exact size of the multiplier in advance due to changing economic conditions.
time lags : there’s a delay between the increase in income and it’s full effect on the economy.
effects of changes in AD (multiplier) :
the multiplier increases AD more than the original injection, yet it needs sufficient spare capacity in the economy for it to raise output, not just prices.
AS curve elasticity (multiplier) :
perfectly inelastic AS (classical LRAS) : the multiplier only raises prices in the long run, not output.
elastic AS : the more elastic the curve, the larger the effect on output, and the smaller the effect on prices.
short run vs long run (multiplier) :
the impact of the multiplier depends on whether the economy is in the LR or SR.
in the LR, the effect on output is limited if AS is inelastic.
optimal conditions for the multiplier :
higher MPC and low MPW and plenty of spare capacity cause larger effects on output.
low spare capacity causes higher prices but little effect on output.
at Y the economy is below FE.
the government looks to increase spending to increase employment, moving equilibrium to Y1.
however, the multiplier effect means that AD will increase beyond the initial injection by the government.
this shifts demand from AD1 to AD2.
a new equilibrium is at Y2.
at FE, the policy will be counterproductive and only cause inflationary pressure.
3 methods of measuring economic growth using GDP :
- Income : adding up all factor incomes earned in a year (e.g. profits, salaries)
- Output : looking at the final value of all goods/services produced in an economy in a year.
- Expenditure : consumer expenditure, adding up all the expenditure on a country’s goods/services within a year.
Higher unemployment - multiplier
When there is higher unemployment, firms can more easily expand their production to meet increased demand because there are more available workers.
When demand rises, firms can hire additional workers without worrying about labor shortages.
These workers earn income and spend it, which stimulates additional demand.
