How the macroeconomy works: the circular flow of income, aggregate demand/aggregate supply analysis and related concepts

National income

Total value of the goods and services a country produces per year - measured by GDP,GNP,GNI

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Circular flow of income

Households supply firms with the factors of production - receive wages and dividends - firms supply goods and services to households - consumers pay firms for these

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Full employment income

The total output of an economy when unemployment is minimised or is at the government target

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The circular flow of income diagram

.

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Circular flow of income formula

National output = National income = National expenditure

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National output

All of the goods and services produced by firms

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National expenditure

The money spent from national income that makes up total expenditure

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Injections into the circular flow of income

Money which enters the economy - gov spending, investment and exports

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Withdrawals into the circular flow of income

Money which leaves the economy - Taxes, saving and imports

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Net injections leads to an

Expansion of national output

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Net withdrawals leads to a

Contraction of production, so output decreases

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UK trend of savings and investment

Traditionally low

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Amount of savings in an economy is equal to....

the amount of investment

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The multiplier effect

An initial change in AD and the resulting usually larger change in national income - depends on the rate at which money leaks from circular flow

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Wealth

Total value of all the assets owned by individuals or firms in an economy - stock concept - aren't currently being used in the circular flow of income but could be at some point

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Income

A flow of money - individuals with high incomes tend to have high wealth because they'll be able to purchase more expensive assets and have more money to save

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Nominal income

Hasn't been adjusted for inflation

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Real income

Has been adjusted for inflation

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Aggregate demand is the total

demand/spending in the economy

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Aggregate demand formula

AD=Consumption(C)+Investment(I)+Government spending(G)+(Exports(X)-Imports(M))

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What is the difference between AD and National expenditure?

AD - measures planned spending, National expenditure - measures realised or actual spending

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What causes movements along the AD curve?

Changes in price

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Why does the AD curve slope downwards?

Higher prices - fall in value of real incomes - goods less affordable in real terms, high domestic inflation - foreign goods relatively cheaper - deficit ^ - AD falls, High inflation - interest rates^

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A rise in AD is occurs when......

AD shifts to the right - higher confidence levels, lower interest rates, lower taxes, increase in gov spending, depreciation in currency,credit more available

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What is the wealth effect?

The link between the level of personal wealth and our decisions about how much to spend or save on goods and services

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What does the AS curve show?

The quantity of real GDP which is supplied at different price levels in the economy

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Why does the AS curve slope upwards?

At a higher price level, producers are willing to supply more because they can earn more profits

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Movements along the AS curve occur because

of changes in AD which is caused by changes in price

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When does the SRAS curve shift?

Changes in the conditions of supply - cost of employment, cost of other inputs (raw materials, commodity prices, exchange rate), Government regulations/interventions

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SRAS only covers the period......

immediately after a change in the price level - shows planned output of an economy

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What does the LRAS curve show?

The potential supply of an economy in the LR - when prices, and the costs and productivity of factor inputs can change - shows economy's productive potential

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Why is the LRAS curve vertical?

Supply is assumed not to change as the price level changes, all FOP fully employed, output fixed at each level

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Macroeconomic equilibrium is when

AD=AS which is the equivalent to when the rate of withdrawals = the rate of injections

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In the SR, excess supply occurs when

Price is above equilibrium

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In the SR, excess aggregate demand occurs when

Price is below equilibrium

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If the economy becomes more productive, how does this effect Supply?

Will shift to the right - lowers the price and increases national output

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If there is less confidence in the economy, how does this effect Demand?

AD shifts to the left - price level falls and national output falls

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Consumer spending

How much consumers spend on goods, largest component (60% of GDP) - most significant to eco growth

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Disposable income

Income after taxes and social security charges, what consumers choose to spend - consumer income can come from wages,savings,pensions,benefits and investments

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Marginal propensity to consume (MPC)

How a consumer changes their spending following a change in income, the higher the MPC the bigger the size of the multiplier

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Marginal propensity to save (MPS)

The proportion of each additional pound of household income that is used for saving, the higher the MPS the smaller the multiplier

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MPC + MPS =

1

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Influences on consumer spending

Interest rates, Consumer confidence

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How do interest rates effect consumer spending?

IR low - cheaper borrowing - lower cost of debt (more effective disposable income) - reduces incentive to save - spending and investment ^, however time lag makes this not suitable if a rise in AD is needed immediately

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How does consumer confidence effect consumer spending?

Confidence ^ - investment and spending ^ - feel as though they will get a higher return - affected by anticipated income and inflation, low confidence - spend less save more - delay large purchases

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Capital investment

Accounts for 15-20% of GDP - 3/4 from private sector 1/4 from government - smallest component of AD

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Influences on investment

Rate of economic growth, business expectation and confidence, demand for exports, interest rates, access to credit, influence of government and regulations

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How does the rate of economic growth influence investment?

Growth is high - more revenue - higher consumer spending - more profits available to invest

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How do business expectations and confidence influence investment?

High rate of return - invest more, also includes expectations about society and politics, 'animal spirits'

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How does the demand for exports influence investment?

Higher demand - firms will invest - expect higher sales - direct capital goods into the markets where consumer demand is increasing

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How do interest rates influence investment?

Investment increases as interest rates fall - cost of borrowing is less and return to lending is higher, higher interest rates - greater opportunity cost of not saving money, might make firms expect a fall in consumer spending -discourage investment

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How does the access to credit influence investment?

Banks unwilling to lend - harder to gain access to credit - more expensive or not possible to fund investments - availability of funds is dependent on the level of saving in the economy

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How do governments and regulations influence investment?

Lower taxes means firms keep more profits, which could encourage investment

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The accelerator process

Level of investment is related to the change in GDP - A higher rate of economic growth causes more investment - rate of economic growth is slowing - level of investment might fall - level of investment is more volatile than the rate of eco growth

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Government spending

How much government spends on state goods and services - 18-20% of GDP - third largest component of AD

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Influences on government spending

The trade cycle, fiscal policy

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How does the trade cycle influence government spending?

Recession - gov increase spending to stimulate economy - spending on welfare or cutting taxes - increase gov deficit, Economic growth - Gov may receive more tax - spend less - fewer claiming benefits

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How does fiscal policy influence government spending?

Changing gov spending and taxation - public goods/merit goods - demand-side policy, Discretionary Fiscal policy, Automatic stabilisers, expansionary fiscal policy, contractionary fiscal policy

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Discretionary fiscal policy

Implemented through one-off policy changes

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Automatic stabilisers

Offset fluctuations in the economy - transfer payments and taxes - triggered without gov intervention

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Expansionary fiscal policy

Gov may introduce during economic decline - increasing spending on transfer payments or on boosting AD, or by reducing taxes

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Contractionary fiscal policy

Goc may introduce during economic growth - decreasing expenditure - tax rates may increase - reduces budget deficit

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Exports - imports

Current account on the balance of payments - +ve=surplus - -ve+deficit, UK has a relatively large deficit - reduces AD - Second largest component of AD

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Influences on net trade balance

Real income, Exchange rates, State of the world economy, Degree of protectionism, Non-price factors

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How does real income influence net trade balance?

Eco growth ^ - Higher incomes - afford to consumer more - larger deficit on current account - increase spending on imports, eco decline - real incomes fall - improvements on current account

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How do exchange rates influence net trade balance?

Depreciation of £ - imports £^ - Exports cheaper - current account deficit narrows - currency relatively more competitive - demand for UK exports has to be price elastic to lead to sig increase in exports

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How does the state of the world economy influence net trade balance?

Decline in eco growth in UK export markets - fall in exports - consumer spending fall - falling in real incomes

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How does the degree of protectionism influence net trade balance?

Guarding a country's industries from foreign competition - tariffs,quotas,regulations or embargoes - trade deficit reduce SR (importing less) - LR protectionism leads to retaliation, exports decrease - undoes effect

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How do non-price factors influence net trade balance?

Competitiveness of country's good - supply side-policies - innovation, higher quality, low labour costs, more productive - increase exports, trade deals and trading blocs - influence how much a country exports

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Factors which influence the level of economic activity

Employment, Confidence, Events (natural disasters, holidays), other factors (taxes, interest rates)

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The multiplier ratio

Ratio of the rise national income to the initial rise in AD - number of times a rise in national income is larger than the rise in the initial injection of AD, which led to the rise in national income

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Relationship between the multiplier effect and elastic SRAS

Spare capacity - extra output can be produced quickly - little extra cost - SRAS elastic - Multiplier will be larger - small increase in AD will lead to a large increase in national income

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Relationship between the multiplier effect and inelastic SRAS

SRAS inelastic - multiplier smaller than its potential - if AD increases prices will increase rather than a full increase in national income - higher rate of inflation will lead to higher interest rates

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Reverse multiplier

Withdrawal of income - leads to an even larger decrease in income for the economy - decrease economic growth and potentially lead to a decline in the economy

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Formula for calculating the multiplier

1/(1-MPC) = 1/MPW

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Factors influencing SRAS

Price level, production costs, cost of employment (wages,taxes,labour productivity), cost of other inputs(raw materials,commodity prices,exchange rate), Gov regulation/intervention, red tape, net outward migration of workers 'brain drain'

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Brain drain

Skilled workers move elsewhere

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Factors influencing the LRAS curve

Technological advances, changes in relative productivity, changes in education and skills, changes in government regulations, demographic changes and migration, competition policy

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Keynesian AS curve

PL is fixed until resources are fully employed, horizontal section - resources not fully employed, spare capacity, output changes not inflationary, vertical section - resources fully employed, any increase in output will be inflationary

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Average propensity to consume (APC)

Consumption/total income

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Average propensity to save (APS)

Amount saved/total income

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How the macroeconomy works: the circular flow of income, aggregate demand/aggregate supply analysis and related concepts

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