2.2 How the macroeconomy works: the circular flow of income, AD/AS analysis, and related concepts Flashcards
(60 cards)
1
Q
Household
A
people living under one roof. They demand goods and services, and supply land, labour, capital, and enterprise.
2
Q
Firm
A
a productive organisation which sells its output of goods or services commercially
3
Q
National income (Y)
A
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)
4
Q
National Output (O)
A
the value of all the goods and services produced in a country in a year
5
Q
National expenditure (E)
A
the money spent on all the goods and services in a country in a year
6
Q
Withdrawal (W)
A
a leakage of spending power out of the circular flow of income into savings, taxation, and imports
7
Q
What are the 3 components of total withdrawals?
A
- savings
- taxation
- imports
8
Q
Injection (J)
A
spending entering the circular flow of income as a result of investment, government spending, and exports
9
Q
What are the 3 components of total injections?
A
- investment
- government spending
- exports
10
Q
Savings (S)
A
income which is not spent
11
Q
Investment (I)
A
total planned spending by firms on capital goods produced within the economy
12
Q
Taxation (T)
A
money collected by the government
13
Q
Government spending (G)
A
money spent by the government
14
Q
Imports (M)
A
goods or services produced in other countries and sold to residents of this country
15
Q
Exports (X)
A
goods or services produced in this country and sold to residents of other countries
16
Q
What happens when W=J?
A
national income in equilibrium
17
Q
What happens when W>J?
A
national income is falling
18
Q
What happens when W<J?
A
national income is rising
19
Q
Disposable income
A
income over a period of time including earnings and benefits, less direct taxes
20
Q
Consumption (C)
A
total planner spending by households on consumer goods and services produced within the economy
21
Q
Marginal propensity to consume (MPC)
A
the fraction of an increase in disposable income that people plan to spend on domestically produced consumer goods
22
Q
What is the formula for the marginal propensity to consume?
A
MPC = change in consumption/change in income
23
Q
Average propensity to consume (APC)
A
the fraction of disposable income spent on domestically produced consumer goods
24
Q
What is the formula for average propensity to consume?
A
APC = consumption/income
25
Multiplier (k)
the relationship between an initial change in aggregate demand and the resulting (usually larger) change in national income
26
What is the formula for the multiplier effect?
k=1/(1-MPC)
27
How do you calculate the change in national income from the injection and the multiplier?
ΔY=Jk
28
Equilibrium national income
the level of income at which withdrawals from the circular flow of income equal injections into the flow. Alternatively, the level of real output at which aggregate demand equals aggregate supply.
29
Aggregate
a whole formed by combining several different elements
30
Real
a prefix used in economics to indicate that the value has been adjusted for inflation
31
Price level
the average of all prices of goods in the economy
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Real National output
the value of all goods and services produced in a country in a year adjusted for inflation
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Aggregate demand (AD)
the total planned spending on real output produced within an economy
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Aggregate supply (AS)
the aggregate level of real output that all firms in the economy plan to produce at different price levels
35
What is the formula for AD?
AD = C + I + G + (X - M)
36
What are the determinants of consumption? (8)
- interest rates
- level of income
- expected future income
- wealth
- consumer confidence
- availability of credit
- distribution of income
- expectations of future inflation
37
How do house prices affect consumption?
- increase in house prices often causes homeowners to consume more
- borrowing increases as house buyers take out mortgages, which finances extra consumption
- induces a 'feel-good factor' among property owners, leading to a consumer spending spreee
38
Savings ratio
a measure of actual savings as a ratio of disposable income
39
How do you calculate the savings ratio?
actual saving/disposable income
40
Interest rate
the reward for lending savings to somebody else and the cost of borrowing
41
What are the determinants of investment? (5)
- interest rates
- future maintenance costs of the investment
- relative prices of capital and labour
- nature of technical progress
- adequacy of financial institutions in the supply of investment funds
## Footnote
Interest rates: These represent the cost of borrowing money. Higher interest rates increase the cost of financing investments, making them less attractive, and vice versa. They also affect the opportunity cost of investing compared to other uses of funds, such as saving.
Future maintenance costs of the investment: When considering an investment, businesses must factor in the ongoing expenses required to keep the asset operational over its lifespan. Higher expected maintenance costs will reduce the profitability and attractiveness of the investment.
Relative prices of capital and labour: The cost of capital goods (machinery, equipment, etc.) compared to the cost of labour influences investment decisions. If capital becomes relatively cheaper than labour, firms may be incentivized to invest in more capital-intensive production methods. Conversely, if labour is cheaper, they might opt for more labour-intensive approaches.
Nature of technical progress: Advancements in technology can create new investment opportunities by making new types of capital goods available or by improving the efficiency and productivity of existing ones. The pace and direction of technological change significantly impact the demand for new investments.
Adequacy of financial institutions in the supply of investment funds: The availability and efficiency of financial institutions (banks, capital markets, etc.) in providing funds are crucial for investment. If firms have difficulty accessing loans or raising capital, their ability to invest will be constrained, regardless of the other factors.
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Accelerator effect
a change in the level of investment in new capital goods is induced by a change in the rate of growth of national income or aggregate demand
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Short-run aggregate supply (SRAS)
aggregate supply when the level of capital is fixed, though the utilisation of existing factors of production can be altered so as to change the level of real output
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Incentive function
a higher price creates an incentive for firms to supply more of a good or a service
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Law of diminishing returns
where increasing amounts of a variable factor and added to a fixed factor and the amount added to total product by each unit of the variable factor eventually decreases
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Short-run production
occurs when a firm adds variable factors of production to fixed factors of production
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Long-run aggregate supply (LRAS)
aggregate supply when the economy is producing at its production potential (the maximum sustainable level of output that the economy can currently produce)
48
Macroeconomic long run
a sufficient period of time for nominal wages and other input prices to change in response to a change in the price level; the long run is not any fixed period of time. Instead, this refers to the time it takes for al prices to fully adjust
49
Long run economic growth
an increase in the economy's potential level of real output, and an outward shift of the economy's production possibility frontier
50
What are the determinants of short-run aggregate supply? (5)
- costs of production
- unit labour costs due to a change in wage rates or labour productivity
- taxation
- subsidies
- technical progress of capital goods
51
What are the determinants of long run aggregate supply? (7)
- state of technical progress
- quantities of factors of production in the economy
- mobility of factors of production
- productivity of factors of production
- personal enterprise
- the existence of appropriate economic objective
- the institutional structure of the economy (e.g. efficient contract law and banking system promote long-run economic growth and rightwards shift in LRAS)
52
Quantity theory of money
a theory that states inflation is caused by increases in the money supply
53
Monetarists
economists who argue that inflation is caused by prior increases in the money supply
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Money supply
the stock of money in the economy at a particular point in time
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Velocity of circulation of money
how fast money passes from one holder to the next
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Fisher equation of exchange
the stock of money in the economy multiplied by the velocity of circulation equals the price level multiplied by the quantity of real output in the economy
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Fisher equation of exchange formula
money supply (m) x velocity of circulation of money (v) = price level (p) x quantity of real output (q)
58
Describe what happens when the government increases money supply (5)
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
## Footnote
This explanation describes a simplified version of what can happen when a government increases the money supply. Here's a breakdown of each step and some important economic context:
"The government decides to increase the money supply": Governments typically don't directly print and distribute money. Instead, central banks use various tools to increase the money supply in the economy. These tools include:
Lowering interest rates: This makes borrowing cheaper for banks and consumers, encouraging more lending and spending.
Buying government bonds (Quantitative Easing): This injects money into the banking system, increasing their reserves and ability to lend.
Lowering reserve requirements for banks: This allows banks to lend out a larger portion of their deposits.
"As that money begins to be spent, real incomes rise": When more money is available, initially, people and businesses might have more funds to spend. This increased spending can lead to higher demand for goods and services. In the short term, if businesses can increase production, this can lead to increased economic activity and potentially higher real incomes (income adjusted for inflation) for some as wages or profits rise.
"Causing a fall in the number of times each bank note is exchanged": This refers to the velocity of money, which is the rate at which money changes hands in the economy. If the money supply increases significantly while the overall level of transactions doesn't increase at the same rate, each unit of money will be used less frequently. However, this step is not a direct or guaranteed consequence of an increased money supply. The velocity of money is influenced by various factors like consumer confidence, interest rates, and payment habits, and its response to changes in the money supply can be unpredictable.
"But this causes demand-pull inflation": This is a crucial point. If the increase in the money supply leads to a sustained increase in aggregate demand (total spending in the economy) that outpaces the economy's ability to produce goods and services, it will lead to demand-pull inflation. With "too much money chasing too few goods," businesses can raise prices because consumers are willing and able to pay more.
"Causing real incomes to fall back to initial levels": While some individuals might experience a temporary rise in real income in the short run (as mentioned in point 2), sustained inflation erodes the purchasing power of money. If nominal incomes (in current money terms) don't rise at the same rate as prices, then real incomes will fall. This means people can buy fewer goods and services with the same amount of money, effectively negating the initial increase in real income caused by the increased spending. Eventually, the economy may return to a situation where the initial boost in spending power is offset by higher prices.
Important Considerations:
Time Lags: The effects described above don't happen instantaneously. There are often time lags between an increase in the money supply and its impact on spending, inflation, and real incomes. These lags can be variable and difficult to predict.
State of the Economy: The initial state of the economy is crucial. If the economy is operating below full capacity (i.e., there are unemployed resources), an increase in the money supply might lead to a more significant increase in real output and less immediate inflationary pressure. However, if the economy is already near full capacity, the increase in money supply is more likely to primarily cause inflation.
Expectations: Expectations about future inflation play a significant role. If people expect higher inflation, they may demand higher wages and businesses may raise prices more readily, accelerating the inflationary process.
Other Factors: Inflation is a complex phenomenon influenced by many factors besides the money supply, such as supply-side shocks (e.g., rising oil prices), changes in global demand, and fiscal policy.
59
Assumptions under the quantity theory of money (3)
- money is not saved (it is all spent)
- the economy is at full employment
- velocity of transactions is independent of other variables
60
Why does an increase in the money supply cause inflation?
"too much money chasing too few goods"
