Week 4

Question 1

What are the injections to the circular flow of income?

Answer 1

Investment
Government expenditure
Export expenditure

(I + G + X)

Question 2

What are the withdrawals from the circular flow of income?

Answer 2

Savings
Net taxes
Import expenditure
(S + T + M)

Question 3

What’s gross domestic product (GDP)?

Answer 3

The total value of final goods and services produced in a country at a certain time.

Question 4

What are the three ways to quantify GDP?

Answer 4

The output method – measures GDP by aggregating the value of final goods and services produced in an economy.

The income method – measures GDP by adding up the incomes paid to the factors of production in an economy.

The expenditure method – measures GDP by adding together the amount spent on final goods and services.

Question 5

What’s gross national product (GNP)?

Answer 5

The value of final goods and services produced by domestically-owned factors of production.

Question 6

What’s the difference between nominal and real GDP?

Answer 6

Nominal GDP is the value of production in terms of current prices.

Real GDP is the value of production in terms of constant prices (adjusted for inflation).

Question 7

What’s actual growth?

Answer 7

The % annual increase in output.

Question 8

What’s potential growth?

Answer 8

The speed at which the economy could grow.

Potential output is the level of output that would arise when the economy is operating at ‘normal capacity utilisation’ (a sensible level).

Question 9

What’s the quantity theory of money (QT)?

Answer 9

The main “macro” theory before the 20th century.

The broad idea behind the QT is that prices is an economy are generally proportional to the quantity of money.

QT was first used to explain the rise in prices in Europe following the discovery of gold and silver in South America.

Question 10

What’s the “cost of production theory”?

Answer 10

The pre-20th century idea that the production of money was linked to inflation.

Question 11

What’s the classical viewpoint in economics?

Answer 11

The belief that free markets would result in healthy economies with ‘full employment’ (mainly used until the early 20th century).

Question 12

What’s the Keynesian viewpoint and how did it develop?

Answer 12

It strongly advocated government intervention (fiscal and monetary policies). The interwar period which saw mass unemployment and classical economic theories failed to provide solutions addressing this.

Question 13

How did monetarism develop?

Answer 13

When Keynesianism failed to explain economic events in the 1970s, monetarism became more popular (the belief that the supply of money played a key role in the economy).

Question 14

What are some key areas of argument between classical and keynesian views?

Answer 14

The flexibility of prices and wages.

The nature of aggregate supply.

The role of expectations.

The most appropriate form of policy response.

Question 15

What’s a closed economy and how does it affect total income?

Answer 15

A closed economy is one that doesn’t have any flows to/from other economies in the rest of the world.

In a closed economy: Y = C + I + G

Question 16

What are flexible and sticky prices?

Answer 16

Flexible prices adjust quickly to bring D&S to equilibrium.

Sticky prices mean that D doesn’t always equal S; variables can be slow to adjust.

Question 17

What’s consumption?

Answer 17

Consumption is spending by households on final goods and services.

Consumption depends on disposable income, Y-T (assuming that T doesn’t depend on Y and that C is not impacted by interest rates).

Question 18

What’s a specific functional form of the C function?

Answer 18

Example of a specific functional form of the C function: C = 500 +0.75(Y-T)

The constant term represents autonomous consumption – consumption that’s independent from the income level.

The parameter before the parenthesis is the marginal propensity to consume, which varies with income.

MPC captures households’ inclination to spend their income and it takes a value between 0 and 1.

Question 19

What’s investment?

Answer 19

Investment is defined as spending on things that are not immediately consumed, but rather used in production or stored for later.

Question 20

What are the three types of investment?

Answer 20

‘Business fixed investment’, spending on plants and equipment. (Firms)

‘Inventory investment’, the accumulation of goods inventories. (Firms)

‘Residential fixed investment’, spending on housing units. (Households)

Question 21

What’s the general form of the I function?

Answer 21

We assume that the level of investment depends on the (real) interest rate.

General functional form the I function: I = I(r)

Question 22

What’s government spending?

Answer 22

Government spending is spending on final goods and services by the government.

We assume that G is an exogenous policy variable.

If G=T, the government has a balanced budget.

Governments mostly run budget deficits; we can define national debt as the accumulated sum of budget deficits.

Question 23

What’s aggregate demand?

Answer 23

Aggregate demand is defined as the total demand for all of the final goods and services in the economy.

Question 24

What’s the formula for aggregate demand?

Answer 24

AD = C(Y-T) + I(r) + G

Question 25

How is aggregate supply determined?

Answer 25

By the factors of production:
Capital (K), Labour (L) and the level of technology is denoted in the general form Y=F(K, L)

Question 26

How is the level of r (real interest rates) determined?

Answer 26

With the help of the Loanable Funds Market, a simple demand-supply model of the financial system in which:

Demand for funds is derived from the desire to invest.

The supply of funds comes from savings.

The ‘price’ of funds is the real interest rate.

Question 27

What are the assumptions made when discussing the Loanable Funds Market?

Answer 27

All borrowers go to the Loanable Funds Market to get loans.

All savings are available for lending.

There is a single interest rate which is both the return on saving and the cost of borrowing.

The market is governed by the forced of demand and supply.

Question 28

What are the two key points about the demand for loanable funds?

Answer 28

It comes from investment.

It depends (negatively) on r.

Question 29

Where does the supply of loanable funds come from?

Answer 29

From saving:

Households make deposits at the bank which become available to borrow and finance investment spending.

The government may also contribute to saving if it has a budget surplus.

Question 30

What are the three types of saving?

Answer 30

Private saving is the amount of households’ disposable income that isn’t consumed: (Y-T) – C

Public saving is saving by the government; it is the amount of tax
revenue that is not spent, i.e. T – G

National saving is the sum of private and public saving and can be
found by adding these together: (Y – T) – C + T – G = Y – C – G

Question 31

How do the standard principles of price adjustment apply to the LFM?

Answer 31

If there is a shortage of funds, the price (interest rate) will increase.

If there is a surplus of funds, the price (interest rate) will decrease.

Due to the classical assumptions, such price adjustment is quick
(effectively instantaneous).

Question 32

How does expansionary fiscal policy affect the LFM?

Answer 32

An increase in G corresponds to lower public saving and therefore lower national saving.

…this translates into a leftward shift in the vertical supply curve of the LFM model.

The result is a higher level of r and a lower level of S and I.

Question 33

How is the AD-AS model affected by expansionary fiscal policy?

Answer 33

In AD-AS, expansionary fiscal policy is represented by a rightward shift in AD because G is one of the components of AD.

With classical assumptions, we have a higher P but the same Y. Although G has increased, this is offset by lower I.

Question 34

How does crowding out work in the LFM?

Answer 34

If r increases, I increases.

In essence, investment is ‘crowded out’ by the increase in g.

In the classical model, Y remains unchanged.