Theme 2.4 Flashcards
How does the most basic model of the circular flow of income work?
The most basic form of the model shows a two-sector economy: with just the households and the sellers.
-Households own all the wealth and resources so provide the firms with land, labour and capital in return for rent, wages, interest and profits.
-They use this money to buy goods and services produced by the firms.
-Money (represented by the green arrows) flows in one direction and goods,
services and factors of production (orange arrows) flow in another.
-In this model there are three ways of measuring the level of economic activity: the national output, the value of the flow of goods and services from firms to households; the national expenditure, the value of spending by households on goods and services; and the national income; of income paid by firms to
households in return for land, labour, capital and enterprise.
-In this simple model, the national output=national expenditure=national income
Why is the two-sector model for the circular flow of income too basic in reality to represent the actual economy?
-Firstly, the government needs to be added: they take money out of the economy through taxation (T) and add money by spending (G). If the government spends more than it takes away, it can increase the flow of income.
-Next, we add to the model by introducing financial services who can inject
money into the system through investment (I) and take money away when consumers or producers save (S).
-Finally, foreign markets are added as foreigners buy British goods so exports (X) add money to the flow but British people want to buy foreign goods so imports (M) take money away from the flow. The difference between the level of imports and exports is the balance of trade.
What is the difference between income and wealth?
Wealth is a stock of assets whilst income is a flow. Wealth is the things people own e.g. houses, possessions whilst income is the money they receive e.g. money from work, interest from savings. Countries with high levels of wealth tend to have high levels of income and vice versa but there is not a perfect correlation between wealth and income.
What are the injections?
Injections are monetary additions to the economy:
-government spending (G),
-investment (I)
-exports (X).
What are withdrawals/leakages?
Withdrawals or leakages are where money is removed from the economy:
-taxes (T)
-savings (S)
-imports (M).
What will occur if the withdrawals are not equal to the injections?
If the sum of injections is greater than the sum of leakages/withdrawals, then the economy will be growing whilst if injections are smaller than withdrawals, it will be shrinking.
What must occur for the flow of income to be in equilibrium?
In an equilibrium, injections must be equal to withdrawals and so the national income remains the same.
What is the equilibrium level of national output?
The equilibrium position of national output is where the AD and AS curves intersect. If either AS or AD are shifted, then the equilibrium position will change. The size of this change will depend on the size of the shift and the elasticity of the curve which has not moved i.e. the elasticity of AS if AD has moved.
What do classical economists believe about changes in AD on LRAS?
-As the classical LRAS curve is perfectly inelastic (i.e. a change in price has no effect on change in output), a shift of the AD curve would not affect long run national output and would only affect price levels. Classical economists believe that the economy will always return to full employment level and therefore there will be no unemployment in the long run.
They believe that the increase in AD from AD1 to AD2 will lead to a positive output gap. The economy is in long term disequilibrium as SRAS1 and AD2 do not intersect on the LRAS curve. The short-term equilibrium is P2Y2. This means that there is over-full employment and firms will end up bidding up wages of labour (as each of them offers a higher salary in order to attract the best workers) and the other factor prices. As a result, SRAS shifts to SRAS2asthecostofproductionhasincreased.Eventually,theeconomyisproducingthe same amount but now at higher prices: they are producing at Y1P3. The short run equilibrium has shifted and is now the same as the long run equilibrium.
● Classicists conclude that an increase in AD will increase price and output in the short run but over time, prices will continue to rise as the economy moves back to the long-term equilibrium. Therefore, output has not changed and the only way to increase output is by increasing the LRAS. Changes in AD without a change in the LRAS are only inflationary.
What is classical economists believe is the only way increase national output in the long run?
A rise in long run aggregate supply is likely to lead to lower prices and higher output. When this is compared to a rise in AD which causes increase prices and no higher output, it is clear to see why classical economists favour supply-side policies over demand management
What do Keynesian economists believe about the relationship between AD and LRAS?
● Keynesian economists agree with classicists that there is full employment where the LRAS is vertical. However, they believe 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 real wages.
● 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, for example at AD1, then a rise in LRAS will increase output and decrease the price level. This is seen by the change in equilibrium from P1Y1 to P2Y2 following the shift. However, if the economy is in a deep recession, for example producing at AD2, then an increase in LRAS will have no effect on prices or output. This is shown by the fact the equilibrium is still at P3Y3.
● This is why Keynesians argue that during recessions the government needs to work to increase AD rather than using supply side policies.
What is the relationship between increasing AD and Supply?
In microeconomics, any factor which affected demand would not affect supply and vice versa. However, with macroeconomics, a factor which affects AD can easily affect AS. One example of this could be investment: investment is a component of AD so an increase in investment will increase AD but it could also increase LRAS as firms are able to produce more if they have more machines etc. This may mean that the long run disequilibrium caused by the shift in AD will be brought back to equilibrium by an increase in LRAS rather than a fall in AD. However, not all investment results in increased production (e.g. a firm may invest but then go out of business) and so the LRAS will not increase. Therefore, the extent to which investment increases output and lessens inflation depends on its rate of return.
What is the multiplier effect?
The multiplier process is the idea that an increase in AD because of an increased injection (exports, government spending or investment) can lead to a further increase in national income.
What is the multiplier ratio?
● It is the ratio of the final change in income to the initial change in injection; and the figure multiplied by the original injection to find the final change in income.
● The initial injection will represent an increase in spending and will increase income for someone else which will then lead to further consumption spending. For example, if the government spends £100m to create jobs and withdrawals are taken into account, the £100m of government spending could lead to an extra £90m being spent by those who have the jobs, of which another £81m will be spent by those who received the £90m and so on. In this case, the MPC is 0.9 and the multiplier is 10. The extra consumption creates more jobs and increases output.
What is the size of the multiplier determined by?
The size of the multiplier will be determined by how much of an increase in income people will spend, the marginal propensity to consume (MPC). The lower the leakages, the higher the MPC, the bigger the multiplier.
