9.1 The circular flow of income Flashcards
What are closed and open economies?
A closed economy is entirely self-sufficient, so it has no need to import anything, and it does not export anything. Everything consumed is produced within the border.
An open economy trades with other economies.
The circular flow of income between households, firms, the
government and the international economy
Firms and households interact and exchange resources in an economy.
Households supply firms with the factors of production, such as labour and capital, and in return, they receive wages and dividends.
Firms supply goods and services to households. Consumers pay firms for these.
This spending and income circulates around the economy in the circular flow of income, which is represented in the diagram above.
Saving income removes it from the circular flow. This is a withdrawal of income.
Taxes are also a withdrawal of income, whilst government spending on public and merit goods, and welfare payments, are injections into the economy.
International trade is also included in the circular flow of income. Exports are an injection into the economy, since goods and services are sold to foreign countries and revenue in earned from the sale. Imports are a withdrawal from the economy, since money leaves the country when goods and services are bought from abroad.
The economy reaches a state of equilibrium when the rate of withdrawals = the rate of injections.
What is the difference between an injection and a withdrawal?
An injection into the circular flow of income is money which enters the economy.
This is in the form of government spending, investment and exports.
A withdrawal from the circular flow of income is money which leaves the economy.
This can be from taxes, saving and imports.
If there are net injections into the economy, there will be an expansion of national output.
If there are net withdrawals from the economy, there will be a contraction of production, so output decreases.
What is the multiplier?
The multiplier effect occurs when there is new demand in an economy. This leads to an injection of more income into the circular flow of income, which leads to economic growth. This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created.
The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income.
It occurs since ‘one person’s spending is another person’s income’.
What is the multiplier formula?
1/1-MPC or 1/MPW (MPS + MPT + MPM)
Consume or withdraw
What is MPC and APC?
The marginal propensity to consume (MPC) measures the proportion of extra income that is spent on consumption.
The bigger the MPC the bigger the multiplier
The government could influence the MPC by changing the rate of direct tax. If consumers have more disposable income due to lower income tax rates, their propensity to consume might increase.
MPC = change in consumption over change in disposable income
The average propensity to consume is the percentage of income spent rather than saved. It is calculated by total consumption divided by total income.
What is MPS and APS?
A consumer’s marginal propensity to save is the proportion of each additional pound of household income that is used for saving.
The average propensity to save is the income that is not spent. This is also known as the savings ratio.
MPW = MPS + MPT + MPM
Components of AD and their determinants?
Aggregate demand is the total demand in the economy. It measures spending on goods and services by consumers, firms, the government and overseas consumers and firms.
It is made up of the following components, which make up the equation: C + I + G +(X-M)
o Consumer spending: This is how much consumers spend on goods and services. This is the largest component of AD and is therefore most significant to economic growth.
o Capital investment: This accounts for around 15-20% of GDP in the UK per annum, and about ¾ of this comes from private sector firms. The other ¼ is spent by the government on, for example, new schools. This is the smallest component of AD.
o Government spending: This is how much the government spends on state goods and services, such as schools and the NHS. It accounts for 18-20% of GDP. Transfer payments are not included in this figure, because no output is derived from them, and it is simply a transfer of money from one group of
people to another. Government spending is the third largest component of AD.
o Exports minus imports: This is the value of the current account on the
balance of payments. A positive value indicates a surplus, whilst a negative
value indicates a deficit. The UK has a relatively large trade deficit, which
reduces the value of AD. This is the second largest component of AD.
Autonomous and induced consumer expenditure
Autonomous consumer expenditure refers to the amount of spending that is not influenced by changes in income or other economic factors. This includes spending on necessities such as food, housing, and healthcare. Induced consumer expenditure, on the other hand, is influenced by changes in income and other economic factors.
Autonomous and induced savings
Autonomous savings refer to the portion of savings that is not influenced by changes in income or other economic factors. This can include savings for emergencies, retirement, or other long-term goals. Induced savings, on the other hand, are influenced by changes in income or other economic factors.
Autonomous and induced investment (The accelerator)
Autonomous investment does not depend on income, output or interest rates. Induced investment is in response to the level of income and interest rates.
The accelerator effect occurs when an increase in demand leads to an even bigger increase in investment.
Firms increase production and use their productive capacity more fully. If demand increases significantly, the firm might increase investment to further their productive capacity. Therefore, the demand for capital goods increases as a result of an increase in the demand for consumer goods.
Inflationary and deflationary gaps; full employment level of income and equilibrium level of income
At the equilibrium level of income, there is no tendency for income or output to rise or fall.
An inflationary gap occurs when AD exceeds AS at the level of full employment. It causes the average price level to rise.
A deflationary gap occurs when AD is below AS at full employment, so there is a deficiency in demand. This leads to a fall in output, employment and income. It puts downward pressure on the average price level.
