2.5.2 circular flow of income, expenditure and output

Question 1

What is the circular flow of income?

Answer 1

The interaction of firms and households, exchanging resources in an economy.

Question 2

What do households supply firms with?

Answer 2

The factors of production, such as labour an capital in return for wages and dividends.

Question 3

What do firms supply to households?

Answer 3

Goods and services, which are paid for by consumers.

Question 4

What are some withdrawals in the circular flow of income? [3]

Answer 4

• Saving
• Taxes
• Imports

Question 5

What are some injections into the circular flow of income? [3]

Answer 5

• Government spending
• Exports
• Investment

Question 6

When does an economy reach a state of equilibrium?

Answer 6

When the rate of withdrawals = the rate of injections.

Question 7

What is important to remember when considering circular flow?

Answer 7

That income = output = expenditure

Question 8

What is an injection into the circular flow of income?

Answer 8

Money which enters the economy.

Question 9

What is a withdrawal in the circular flow of income?

Answer 9

Money which leaves the economy.

Question 10

What happens if there are net injections into the economy?

Answer 10

There will be an expansion of national output.

Question 11

What happens if there are net withdrawals from the economy?

Answer 11

There will be a contraction of production, so output decreases.

Question 12

What is aggregate demand?

Answer 12

The total demand in the economy.

Question 13

What does AD measure?

Answer 13

Spending on goods and services by consumers, firms, the government and overseas consumers and firms.

Question 14

What is the equation for aggregate demand?

Answer 14

C + I + G + (X-M)

Question 15

What are the components of aggregate demand? [4]

Answer 15

• Consumer spending
• Investment
• Government spending
• Exports minus imports

Question 16

How much of GDP does consumer spending make up?

Answer 16

Just over 60% of GDP and is the largest component of aggregate demand.

Question 17

What is disposable income?

Answer 17

The amount of income consumers have left over after taxes and social security charges have been removed. It is what consumers can choose to spend.

Question 18

Where might consumer income generate from? [5]

Answer 18

• Wages
• Savings
• Pensions
• Benefits
• Investments

Question 19

How do interest rates influence consumer spending?

Answer 19

If the MPC lower interest rates, it is cheaper to borrow and reduces the incentive to save, so spending and investment increase.

Lower interest rates also lower the cost of debt, such as mortgages.

Question 20

Why is changing interest rates not suitable if a rise in AD is needed immediately?

Answer 20

There are time lags between the change in interest rates and the rise in AD.

Question 21

How does consumer confidence impact consumer spending?

Answer 21

If consumers and firms have higher confidence levels, they invest and spend more because they feel as though they will get a higher return on them. This is affected by anticipated income and inflation.

If consumers fear unemployment or higher taxes, consumers may feel less confident about the economy, so they are likely to spend less and save more.

Question 22

How much of GDP does capital investment account for?

Answer 22

15-20% of GDP in the UK per annum. 3/4 comes from private sector firms whilst the other 1/4 is spent by the government.

Question 23

How much of AD does capital investment take up?

Answer 23

It is the smallest component of AD.

Question 24

What influences are there on investment? [6]

Answer 24

• Rate of economic growth
• Business expectations and confidence
• Demand for exports
• Interest rates
• Access to credit
• Influence of government and regulations

Question 25

How does the rate of economic growth influence investment?

Answer 25

If growth is high, firms will be making more revenue due to higher rates of consumer spending. This means they have more profits available to invest.

Question 26

How do business expectations and confidence influence investment?

Answer 26

If firms expect a high rate of return, they will invest more. They need to be certain about the future.

Question 27

How does demand for exports influence investment?

Answer 27

It is related to the rate of market demand. The higher demand there is, the more likely it is that firms will invest. This is because they expect higher sales, so they might direct capital goods into markets where consumer demand is increasing.

Question 28

How do interest rates influence investment?

Answer 28

Investment increases as interest rates fall, as it means cost of borrowing is less and return to lending is higher. The higher interest rates are, the greater the opportunity cost of not saving the money. High interest rates might make firms expect fall in consumer spending, which discourages investment.

Question 29

How does access to credit influence investment?

Answer 29

If banks and lenders are unwilling to lend, such as shortly after the financial crisis in 2008, firms will find it harder to gain funds for investment. However, firms could use retained profits. Availability of funds is dependent on the level of saving in the economy.

Question 30

How do government regulations influence investment?

Answer 30

The rate of corporation tax could affect investment. Lower taxes means firms keep more profits, which could encourage investment.

Question 31

How much of GDP does government spending account for? Why are transfer payments not included in the figure?

Answer 31

18-20%. This is due to the fact there is no output derived from transfer payments.

Question 32

How much of AD does government account for?

Answer 32

It is the 3rd largest component of AD.

Question 33

What influences are there on government expenditure? [2]

Answer 33

- Economic growth - Fiscal policy

Question 34

How does economic growth influence government expenditure?

Answer 34

During recessions, governments might increase spending to try and stimulate the economy. This will increase the government deficit, and the may have to finance this.

Question 35

What does fiscal policy involve?

Answer 35

Changing government spending and taxation to control the economy.

Question 36

What type of policy is fiscal policy?

Answer 36

It is a demand-side policy, so it works by influence the level or composition of AD.

Question 37

What is discretionary fiscal policy?

Answer 37

Is a policy which is implemented through one of policy changes.

Question 38

When may government use expansionary fiscal policy?

Answer 38

During periods of economic decline, with the aim to stimulate the economy by increasing government spending, decreasing taxes or a combination of both. It ultimately leads to increased AD.

Question 39

When may governments use contractionary fiscal policy?

Answer 39

During periods of economic growth, where it aims to slow down an over-heating economy by decreasing aggregate demand. Tax rates may increase, but this reduces the size of the government budget deficit.

Question 40

What does a positive value on the balance of payments indicate?

Answer 40

A surplus, whilst a negative indicates a deficit.

Question 41

What is the UK's balance of payments?

Answer 41

Has a relatively large trade deficit, which reduces the value of AD.

Question 42

How much of AD does the balance of payments account for?

Answer 42

It is the 2nd largest component of AD.

Question 43

What are the main influences on the net trade balance? [5]

Answer 43

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

Question 44

How does real income affect trade balance?

Answer 44

When consumers have higher incomes, they can afford to consumer more and so there is a large deficit on the current account. When consumers increase their spending, they consumer more domestic products as well as more imports. During economic decline, real incomes fall and previously this has led to improvements in the UK's current account.

Question 45

How do exchange rates influence the balance of payments?

Answer 45

A depreciation of the pound means imports are more expensive and exports are cheaper, and so the current account trade deficit narrows. Depreciations make the currency relatively more competitive against other currencies.

Question 46

How does the state of the world economy influence balance of payments?

Answer 46

A decline in economic growth in one of the UK's export markets means there will be a fall in exports, due to decreased consumer spending in those economies because of falling real incomes.

Question 47

What is the UK's largest export market?

Answer 47

The EU.

Question 48

How does protectionism influence trade balance?

Answer 48

If the UK employed several protectionist measures, then the trade deficit will reduce as they will be importing less due to tariffs and quotas on imports to the UK. However, protectionism leads to retaliation and so exports might decrease too, undoing the effect of reduce imports.

Question 49

When does the AS curve shift?

Answer 49

When there are changes in the conditions of supply.

Question 50

What are the main determinants of Short Run Aggregate Supply?

Answer 50

Price level and production costs.

Question 51

What could shift the AS curve? [5]

Answer 51

- Cost of employment might change e.g. wages, taxes and labour productivity. - Cost of other inputs e.g. raw materials, commodity prices and the exchange rate - Government regulation or intervention, such as environmental laws or green taxes and business regulation - Could be a net outward migration of workers, which causes 'brain drain' on the domestic economy - If there is fall in business capital spending, supply will fall