2.2 How the macroeconomy works: the circular flow of income, AD/AS analysis, and related concepts

Question 1

Household

Answer 1

an individual or group of people living together who make joint economic decisions, particularly about consumption, saving, and labour supply.

Question 2

Firm

Answer 2

a productive organisation which sells its output of goods or services commercially

Question 3

National income (Y)

Answer 3

all the incomes generated from producing goods and services in a country in a year. This included wages (from labour), rent (from land), interest (from capital), and profit (from enterprise)

Question 4

National Output (O)

Answer 4

the value of all the goods and services produced in a country in a year

Question 5

National expenditure (E)

Answer 5

the money spent on all the goods and services in a country in a year

Question 6

leakages

Answer 6

a leakage of spending power out of the circular flow of income into savings, taxation, and imports

Question 7

What are the 3 leakages?

Answer 7

• savings (S)
• taxation (T)
• imports (M)

Question 8

Savings (S)

Answer 8

income which is not spent

Question 9

Taxation (T)

Answer 9

money collected by the government

Question 10

Imports (M)

Answer 10

goods or services produced in other countries and sold to residents of this country

Question 11

Injection

Answer 11

spending entering the circular flow of income as a result of investment, government spending, and exports

Question 12

What are the 3 injections?

Answer 12

• investment (I)
• government spending (G)
• exports (X)

Question 13

Investment (I)

Answer 13

total planned spending by firms on capital goods produced within the economy

Question 14

Government spending (G)

Answer 14

money spent by the government

Question 15

Exports (X)

Answer 15

goods or services produced in this country and sold to residents of other countries

Question 16

What happens when injections<leakages

Answer 16

reduction in economic growth

Question 17

What happens when injections>leakages

Answer 17

increase in economic growth

Question 18

What happens when injections = leakages

Answer 18

macroeconomic equilibrium

Question 19

Disposable income

Answer 19

the amount of money a household has left to spend or save after paying taxes.

Formula:
DisposableIncome=GrossIncome−Taxes

Question 20

Consumption (C)

Answer 20

total planned spending by households on consumer goods and services produced within the economy

Question 21

Marginal propensity to consume (MPC)

Answer 21

the proportion of any extra (additional) income that a consumer spends on goods and services, rather than saving it.

🔹 Formula:

MPC= ChangeinConsumption/ChangeinIncome
​

Question 22

What is the formula for the marginal propensity to consume?

Answer 22

MPC = change in consumption/change in income

Question 23

Average propensity to consume (APC)

Answer 23

the fraction of disposable income spent on domestically produced consumer goods

Question 24

What is the formula for average propensity to consume?

Answer 24

APC = consumption/income

Question 25

Multiplier (k)

Answer 25

the relationship between an initial change in aggregate demand and the resulting (usually larger) change in national income

Question 26

What is the formula for the multiplier effect?

Answer 26

k=1/(1-MPC)

Question 27

How do you calculate the change in national income from the injection and the multiplier?

Answer 27

ΔY=Jk

Question 28

Equilibrium national income

Answer 28

the level of income at which withdrawals from the circular flow of income equal injections into the flow. -the level of real output at which AD=AS

Question 29

Aggregate

Answer 29

the total or overall amount of something in the economy.

Question 30

Real

Answer 30

a prefix used in economics to indicate that the value has been adjusted for inflation

Question 31

Price level

Answer 31

the average of all prices of goods in the economy

Question 32

Real National output

Answer 32

the value of all goods and services produced in a country in a year adjusted for inflation

Question 33

Aggregate demand (AD)

Answer 33

the total planned spending on real output produced within an economy

Question 34

Aggregate supply (AS)

Answer 34

the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels, over a given period of time.

Question 35

What is the formula for AD?

Answer 35

AD = C + I + G + (X - M)

Question 36

What affects consumption? (4)

Answer 36

Consumer confidence ↑ → AD shifts right. Interest rates ↓ → borrowing/spending ↑ → AD right. Taxes ↓ → disposable income ↑ → AD right. Wealth ↑ (e.g. rising house prices) → AD right. ✅ Opposite changes shift AD left.

Question 37

What affects investment? (3)

Answer 37

Business confidence ↑ → investment ↑ → AD right. Interest rates ↓ → cost of borrowing ↓ → investment ↑ → AD right. Government investment incentives (e.g. tax breaks) → AD right.

Question 38

How do house prices affect consumption?

Answer 38

🔑 1. Wealth effect: When house prices rise → homeowners feel wealthier because the value of their main asset increases. This can make them more willing to spend, even if their income hasn’t changed. Some may borrow against their home’s higher value (equity withdrawal) to finance spending. ✅ Higher house prices → consumption increases → AD shifts right. 🔑 2. Confidence effect: Rising house prices signal a strong economy or good future prospects. People feel more confident in their financial situation → more likely to spend rather than save. ✅ Falling house prices → negative wealth and confidence effect → people may cut spending to rebuild savings → AD shifts left. ✅ Evaluation points: Impact depends on proportion of homeowners vs renters in the economy. Equity withdrawal rules or credit conditions affect ability to borrow against home value. Rising house prices won’t increase consumption for those priced out of the market.

Question 39

Savings ratio

Answer 39

a measure of actual savings as a ratio of disposable income

Question 40

How do you calculate the savings ratio?

Answer 40

actual saving/disposable income

Question 41

Interest rate

Answer 41

-the reward for lending savings to somebody else - the cost of borrowing

Question 42

Accelerator effect

Answer 42

The accelerator effect occurs when an increase in national income (GDP) leads to a proportionately larger increase in investment by firms.

Question 43

Short-run aggregate supply (SRAS)

Answer 43

Short-run aggregate supply (SRAS) shows the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels, holding factor costs (like wages) constant. 👉 In the short run, wage rates and other input costs are fixed → so firms respond mainly by adjusting output rather than costs.

Question 44

Incentive function

Answer 44

a higher price creates an incentive for firms to supply more of a good or a service

Question 45

Law of diminishing returns

Answer 45

If increasing quantities of a variable factor (like labour) are added to a fixed factor (like capital or land), eventually the marginal product (extra output per additional unit of the variable factor) will begin to fall.

Question 46

Long-run aggregate supply (LRAS)

Answer 46

aggregate supply when the economy is producing at its production potential (the maximum sustainable level of output that the economy can currently produce)

Question 47

Macroeconomic long run

Answer 47

The macroeconomic long run refers to a period of time in which all factors of production are variable, and the economy has fully adjusted to any changes. In the long run, the economy operates at its full productive potential (also called full employment level of output).

Question 48

Long run economic growth

Answer 48

an increase in the economy's potential level of real output, and an outward shift of the economy's production possibility frontier

Question 49

What affects short-run aggregate supply? (7) costs rise? costs fall? evaluation? (4)

Answer 49

FACTOR----> EFFECT ON SRAS Wage rates ↑ wages → ↑ costs → SRAS shifts **left**; ↓ wages → SRAS shifts **right** | | **Raw material prices** | ↑ oil prices → SRAS **left**; ↓ raw material prices → SRAS **right** | | **Energy costs** | ↑ energy costs → ↑ costs → SRAS **left** | | **Exchange rates** | Currency depreciation → ↑ import prices → SRAS **left**; appreciation → cheaper imports → SRAS **right** | | **Business taxes (e.g. VAT, employer NICs)** | ↑ taxes → ↑ costs → SRAS **left**; ↓ taxes → ↓ costs → SRAS **right** | | **Productivity improvements** | ↑ productivity → ↓ unit costs → SRAS **right** | | **Supply-side shocks** | Natural disaster/pandemic → supply chain disruptions → SRAS **left** | COSTS: → If costs rise → SRAS shifts left → price level ↑, real GDP ↓ (cost-push inflation). → If costs fall → SRAS shifts right → price level ↓, real GDP ↑. EVALUATION: Impact depends on magnitude of cost changes. Some factors are temporary (e.g. oil price shocks), others persistent. Firms may absorb higher costs (reducing profit margins) rather than raising prices → depends on price elasticity of demand. Supply-side policies can shift LRAS as well as SRAS over time.

Question 50

What affects long run aggregate supply? (7)

Answer 50

quantity of labour quality of labour investment in capital technological progress labour market flexibility - easier hiring -reduces structural unemployment Institutional factors → Stable legal, political, and financial systems encourage investment and entrepreneurship Natural resources availability → Discovery or better use of natural resources increases capacity (e.g. new oil reserves)

Question 51

Quantity theory of money

Answer 51

a theory that states inflation is caused by increases in the money supply

Question 52

Monetarists

Answer 52

economists who believe that controlling the money supply is the key to managing the economy, especially for controlling inflation.

Question 53

Money supply

Answer 53

the stock of money in the economy at a particular point in time

Question 54

Describe what happens when the government increases money supply (5)

Answer 54

1) the government decides to increase the money supply 2) as that money begins to be spent, real incomes rise 3) causing a fall in the number of times each bank note is exchanged 4) but this causes demand-pull inflation 5) causing real incomes to fall back to initial levels

Question 55

Assumptions under the quantity theory of money (3)

Answer 55

- money is not saved (it is all spent) - the economy is at full employment - velocity of transactions is independent of other variables

Question 56

Why does an increase in the money supply cause inflation?

Answer 56

An increase in the money supply causes inflation because it leads to more money chasing the same amount of goods and services, driving up prices. This is explained by both the Quantity Theory of Money and demand-pull inflation.

Question 57

Cost-push inflation

Answer 57

Inflation caused by an increase in costs of production, leading firms to raise prices to protect profit margins. ➡️ Higher costs → leftward shift of short-run aggregate supply (SRAS) → higher price level, lower real GDP.

Question 58

Demand-pull inflation

Answer 58

Inflation caused by excess aggregate demand (AD) in the economy, where demand grows faster than the economy’s productive capacity. ➡️ Increased demand → rightward shift of AD → higher price level, higher real GDP (at least initially).

Question 59

draw circular flow of income diagram how can you calculate gdp?

Answer 59

Question 60

what affects government spending

Answer 60

Economic cycle ↑ in recession; ↓ in boom Fiscal policy stance Depends on expansionary vs contractionary Debt level High debt → may cut spending Demographics Ageing population → ↑ spending Political priorities Depends on government objectives Crises/shocks ↑ emergency spending Interest payments ↑ debt cost → ↓ funds for other areas

Question 61

what affects net exports (x-m)

Answer 61

-Foreign incomes ↑ → demand for UK exports ↑ → AD right. -spiced -ad left -wpidec ad right -Strong global demand → AD right.

Question 62

what is a boom

Answer 62

A period of strong economic growth above the long-term trend rate → leading to high output, employment, and demand. 👉 The economy grows rapidly, but may risk inflationary pressure. 🔑 Characteristics of a boom: Falling unemployment Rising incomes and consumption High business profits Rising inflation (demand-pull inflation likely) Possible balance of payments deficits (high import demand) ✅ Economy operating close to or beyond full capacity → risk of overheating.

Question 63

what is a recession

Answer 63

A period of negative economic growth (i.e., a fall in real GDP) for two consecutive quarters or more. 👉 In simple terms: the economy shrinks → less output, lower incomes, higher unemployment. 🔑 Characteristics of a recession: Rising unemployment Falling consumer spending Falling business investment Lower business profits Possible deflation or very low inflation Government tax revenues fall, welfare payments rise ✅ Officially defined by two consecutive quarters of negative real GDP growth.