Topic 1- Circular flow of income and National income

Question 1

What are the terms for positive or negative growth in GDP?

Answer 1

expansion and contraction

Question 2

What does a quarterly GDP growth chart show compared to annual?

Answer 2

. More accurate as to what is happening

.shows business cycle

Question 3

What is the circular flow of income? CIF

Answer 3

Framework for examining linkages between different parts of the economy

Shows inputs, outputs and payments between households and firms within an economy

Question 4

How Can the CIF be used?

Answer 4

. Designing methods to measure Gross Domestic Product (GDP)
. Predicting the impact of various ‘shocks’ on the economy, e.g.
-reduced investment by companies because they think there will be slower growth in sales
-increased government expenditure

Question 5

What is the framework for the CIF?

Answer 5

. Households own factors of production:

. Firms use factors to produce goods and services. Firms reward households financially for use of factors.

. Households purchase (expenditure) goods & services from firms

. Firms use money from sales to pay (income):

• landowners’ rents
• workers’ wages & salaries
• dividends & interest on borrowed funds
• owners’ profits

Question 6

What are the factors of production?

Answer 6

land
labour
capital: both physical (e.g. retail space) & financial
enterprise or entrepreneurship → involves risk taking

Question 7

Define total income (components)

Answer 7

wages + rents + profits + interest

Wages: factor income for supply labour, e.g.
wages, salaries, bonuses

Rent: factor income from supplying land

Profits, interest & dividends on shares: factor
income from supplying entrepreneurship & capital

Question 8

What is the definition of leakages?

Answer 8

income that is not spent (directly) on goods & services within the economy

Question 9

What are the types of leakages? explain each

Answer 9

. total or aggregate saving = S

e.g. saving for a new house, for your children’s education etc.

. total taxes = T

e.g. income & tax on dividends etc.

. import expenditure = M

e.g. French wine, oil, machinery

Question 10

What is the definition of injections?

Answer 10

Additional spending on goods and services that does not come directly from income earned by households

Question 11

What types of injections are there? explain each

Answer 11

. investment = I
(money from people’s savings)
e.g. in new retail space, new IT equipment, new roads

. government expenditure = G

e.g. tax rev on school education & health care services

. export expenditure = X

e.g. pharmaceuticals, overseas students, banking & other financial services

Question 12

Define total expenditure (components)

Answer 12

consumption + investment + gov’t expenditure + net exports

. Consumption: households’ spending goods and services
. Investment: spending on capital products by firms
. Gov’t expenditure – Gov’t spending on public goods and services, (e.g. roads, education)
. Net exports: difference between exports and imports

Question 13

What are the 3 ways of measuring GDP from the CIF model?

Answer 13

. Production (output)
. Income
. Expenditure

They should all equal the same value

Question 14

What is the expenditure method of measuring GDP?

Answer 14

The total value of spending (aggregate expenditure)on goods & services

Question 15

What is the formula for the expenditure method? and breakdown of the components

Answer 15

consumption (C) + investment (I) + government (G)
+ exports (X) - imports (M)

. Consumption: by households

. Investment: gross private & public, e.g. machinery & IT software, roads

Government expenditure, e.g. health, education & defence (excludes welfare transfers, e.g. pensions – as it redistributes income)

Exports: goods & services produced in the UK but consumed overseas

Imports: goods & services produced overseas consumed in UK

Question 16

What is the production/output method?

Answer 16

total value goods & services produced by companies

Question 17

What issues need to be taken into account when measuring GDP using the production/output method?

Answer 17

. Double counting
. Foreign ownership
. Depreciation

Question 18

Explain the issue of double-counting for the production/output method

Answer 18

sum the value-added (net output, after deducting goods and services used up during the production period) at each stage of production to calculate GDP
e.g.dealership buys a car from ford for £12 and sells for £13 so £1 +£12=£13
Counting both the £12 and £13 as GDP would be double counting

Question 19

Explain the issue of foreign ownership for the production/output method

Answer 19

. Toyota owns production facilities in the UK (counts towards GDP) but Tesco income from overseas doesn’t but the flow of profits, interest & dividends from these assets (are property incomes) will go back to home country
. so net property income (balance of flows = income flowing in minus (–) income flowing out ) is taen into account
. So GNP is used as an adjustment of GDP to net property income so that it = income and expenditure method

Question 20

Explain the issue of depreciation for the production/output method

Answer 20

Producing goods uses plant, machinery, building & retail facilities - these depreciate over time
GNI – depreciation = Net National Income (NNI)
Note:depreciation hard to calculate

Question 21

What is the income approach to GDP?

Answer 21

total household earnings: e.g. UK 2013

Wages and salaries: 59% of total GDP

Profits, rent and interest: 35% “ “ “

Mixed incomes*: 6% “ “ “

• remuneration for the work carried out by the owner (or by members of his/her family) of an unincorporated enterprise

Question 22

Explain why GDP needs to take into account price changes?

Answer 22

When GDP increases:
the economy is producing more goods & services

and/or goods & services are being sold at higher prices
so not adjusting to new prices means a potentially misleading GDP

Question 23

What are the two types of GDP?

Answer 23

Real and nominal

Question 24

What is real GDP?

Answer 24

the value of goods & services produced this year, valuing them at the prices that prevailed in some year in the past (base year), constant prices

Question 25

What is nominal GDP?

Answer 25

GDP measured at current prices

Question 26

How and why does GDP need to take into account population size?

Answer 26

In order to measure the standard of living & consumer demand using GDP per capita.
e.g. China >UK in overall GDP
China

Question 27

What is the problem with GDP per capita?

Answer 27

Does not take into account cost of living differences & household income inequality (distribution of wealth)
e.g. Switzerand cost of living is much higher and may not mean they are better off

Question 28

What is the business application of using the GDP level?

Answer 28

. navigating the business cycle: expansion periods (C to A) & contraction periods (A to B) of GDP and therefore aggregate demand
. business owners don’t want to realise a recession or boom in hindsight so capital investments can be managed by using the cycle

Question 29

Give an example of a firm navigating a contraction of the business cycle

Answer 29

Example: supermarket pricing strategies after 2008 recession

. inferior goods demand increases when income falls
normal goods demand declines

. introduction of basic range by supermarkets & increasing market share of Aldi & Lidl supermarkets (foresight)

Question 30

What is an example of the business cycle harming a firm with a lack of adaptability?

Answer 30

Pricing strategies should be adaptable - the experience of Poundworld going into admin 2018
. SIngle price point means it is harder to adapt to a changing economic environment

Question 31

What are the key factors that affect a firms ability to navigate a recession?

Answer 31

. Income elasticities- rise in basic foods
. Pricing-ability to lower prices
. Managing costs-out-sourcing/capacity reduction
. Diversification-products and locations

Question 32

Explain how firms can use diversification to navigate a contraction/recession

Answer 32

. product diversification- VW has a number of different car brands. Lamborghini, prosche will seel well in boom but SEAT and VW cars in contraction
. Market diversification- Bentley found strategic partner in VW and moved int high growth market (China &middle east)-they gained first-mover advantage of luxury cars=barrier t entry in terms of brand/distribution network

Question 33

Why do costs need to be managed during a contraction?

Answer 33

Fixed costs or ‘overhead’ costs are independent of sales or goods produced

Problem: sales are likely to fall when GDP contracts

Question 34

Explain how firms can manage costs in a contraction by reducing capacity

Answer 34

Examples:

- hotels: swimming pools, bars & restaurants
- retailers: rents for retail space
- all: financial debt

Solution:
- capacity reduction → closure of unprofitable hotels & retail space, reduced hours of opening

e.g. M&S plans to close 100+ stores in 2022

Question 35

Explain how firms can manage costs in a contraction by out-sourcing intermediate inputs

Answer 35

BMW out-sourced Engines for some motorbike models by Kymco in Taiwan leading to increased profits

Question 36

How can firms manage expansion period (increasing aggregate demand)?

Answer 36

. Investment projects are more likely to become profitable because they generate extra sales, e.g. retail space, purchase of new machinery

. Willing to take on new risks, e.g. new product development

Taking on more staff to anticipate higher future demand for goods & services

Wage increases? If the economy faces full-employment

Question 37

What are the limitations of GDP as a measure to inform business decisions?

Answer 37

. GDP growth is a backward looking measure & subject to revisions due to new data

Question 38

What are some forward-looking measures businesses can use to inform them about the business cycle?

Answer 38

. business experience:
monitoring orders(increase/decrease) & performance of competitors(are they in the same boat)
speaking to clients

. official economic forecasts

. surveys of consumer confidence: less confidence=less spending

Question 39

What are some examples of economic forecasts that businesses can use?

Answer 39

UK: Office for Budget Responsibility (OBR)

Media: presentation of ‘headline’ data & commentary, Financial Times

Central banks & commercial banks, e.g. Bank of England, European Central Bank, Federal Reserve (USA)

Commercial banks, e.g. Barclays Economic Outlook

Question 40

Explain what the OBR is?

Answer 40

. OBR (Office for Budget Responsibility) created in 2010

. Official independent ‘watchdog‘ of government finances & measures gov performance

. Provides five-year forecasts for the economy & government finances

. Main publication: Economic and Fiscal Outlook – provides detailed commentary & forecasts for the UK economy:

Question 41

Explain what consumer confidence surveys are

Answer 41

GfK produces a widely used consumer confidence index on behalf of the European Commission

Asks 16+ age group a variety of questions concerning the general economic situation of the country & their personal finances

Consumer index (CI) > 0% implies ‘optimistic’ consumers in the majority, i.e. percentage of optimists > percentage of pessimists

CI < 0: ‘pessimistic’ in the majority, e.g. 70% pessimistic & 30% optimistic → minus (-) 40% CI

CI = 0%: ‘neutral’

Question 42

What happened to consumer confidence 2008-2018?

Answer 42

Growing pessimism from the start of 2008: impact of the global financial crisis

Post-Brexit vote in 2016: ‘pessimism’ in the majority but smaller than from 2008 to 2014

Question 43

Where is most of the UK’s production in?

Answer 43

Approx 80% in services-financial services, education, health, real estate, tourism, restaurants, hotels, transport & communication & retail trade