2.4 National Income

Question 1

circular flow of income

Answer 1

• diagram 1
• shows the money flow between households and firms

Question 2

difference between income and wealth

Answer 2

• income is a flow of money that goes to the FoP, e.g. wages, welfare payments, dividends, rents, etc.
• wealth is a stock of assets such as savings, property, bonds, shares, etc.

Question 3

injections and withdrawals in the circular flow of income

Answer 3

• an injection is money that enters the economy through govt. spending, investment, and exports
• a withdrawal (leakage) is money that leaves the economy through taxes, savings and imports
• net injections = expansion of national output
• net withdrawals = contraction of production so decreased output
• equilibrium occurs when rate of withdrawals = rate of injections

Question 4

real national output equilibrium

Answer 4

• occurs when the rate of withdrawals = rate of injections
• this is equivalent to where AD = AS
• it tells us the price level and real GDP of a country

Question 5

shifts in AD on real national output

Answer 5

• an increase in AD (right shift) causes a rise in price level and level of national output
• however, it depends on AS being upward sloping, as the more elastic it is, the more the effect is seen on the growth axis rather than the price axis (spare capacity on Keynesian curve)
• if AS is perfectly elastic (classical), there will be no effect on output, and just an inflationary effect on prices

Question 6

shifts in AS (short-run) on real national output

Answer 6

• a fall in SRAS (left shift) occurs when costs to firms increase, e.g. higher wages of workers due to trade unions, or increase in prices of raw materials
• it leads to a fall in equilibrium output but a rise in price level in the short-run
• a rise in SRAS (right shift), e.g. due to lower corporation tax, causes an increase in real output and a fall in price level

Question 7

shifts in AS (long-run) on real national output

Answer 7

• Classical; increase in LRAS (right shift) leads to lower prices and higher output. decrease in LRAS leads to lower output and higher prices
• Keynesian; an increase in LRAS (right shift) will increase real output and reduce price when AD is near full employment (vertical), but if AD is near spare capacity (horizontal), there will be no effect on price level or national output. decrease in LRAS leads to lower output and higher prices

Question 8

the multiplier ratio

Answer 8

the ratio of change in national income to the injection that created the change
- e.g. real income rose by £15m when the govt injected an extra £5m, so the value of the multiplier would be 3

Question 9

the multiplier process

Answer 9

• refers to how an initial increase in AD leads to an even bigger increase in national income
• this occurs as a rise in AD leads to an injection in the circular flow which leads to economic growth which causes more jobs to be created, higher average incomes, more spending, and eventually more income
• based on the idea that ‘one person’s spending is another person’s income’
• downward multiplier effect can also occur when injections are reduced

Question 10

effects of the multiplier on the economy

Answer 10

• aims to magnify the impact of a change in injections
• e.g. a rise in investment causes more income for companies and workers, more supply, and greater aggregate demand

Question 11

the effect of marginal propensities on the multiplier

Answer 11

• marginal propensity to consume (MPC)
• marginal propensity to save (MPS)
• marginal propensity to tax (MPT)
• marginal propensity to import (MPM)

Question 12

marginal propensity to consume (MPC)

Answer 12

• the proportion of additional income that is spent
• the higher this is, the bigger the size of the multiplier
• the govt. may increase this by reducing direct tax so consumers have more disposable income
• change in consumption / change in income

Question 13

marginal propensity to save (MPS)

Answer 13

• the proportion of additional income that is saved
• if consumers save more than they spend, it’ll reduce the size of the multiplier
• change in saving / change in income

Question 14

marginal propensity to tax (MPT)

Answer 14

• proportion of additional income that is paid in tax
• the higher the rate of tax, the less disposable income consumers have, and the smaller the size of the multiplier
• change in tax / change in income

Question 15

marginal propensity to import (MPM)

Answer 15

• proportion of additional income that is spent on imports
• if this is higher, income is withdrawn from the circular flow of income, thus reducing the size of the multiplier
• change in imports / change in income

Question 16

marginal propensity to withdraw (MPW)

Answer 16

• MPS + MPT + MPM

Question 17

calculating the multiplier

Answer 17

• 1/(1-MPC) (focusing on consumption)
• the greater the MPC, the greater the multiplier value and vice versa
• 1/MPW (focusing on withdrawals)
• the greater the withdrawals, the smaller the multiplier value and vice versa
• impact on GDP = injection x multiplier

Question 18

significance of the multiplier in shifting AD

Answer 18

• if an economy has lots of spare capacity, AS is elastic as extra output can be produced quickly and at little extra cost, so the size of the multiplier will be larger as a small increase in AD will lead to a large increase in national income
• if AS is inelastic, the multiplier effect is likely to be smaller as an increase in AD means price rises more than national income, so it’s inflationary and can lead to higher IR which discourages borrowing / spending and encourages saving (withdrawal)