macro - the circular flow of income

Question 1

what is the circular flow of income?

Answer 1

a model which describes the relationship between total flow of income, output and expenditure in an economy. It suggests the total level of economic activity can be measured 3 ways regarding the aforementioned terms above.

Question 2

what are factor services?

Answer 2

services that are generated by using the factors of production e.g. land.

Question 3

give examples of factor services

Answer 3

households own land, labour and capital used to produce goods and services.

Question 4

what are factor incomes?

Answer 4

income derived from selling factor services.

Question 5

what do households use the factor incomes for?

Answer 5

to buy goods and services (expenditure)

Question 6

what are the assumptions made by the circular flow of income?

Answer 6

a closed economy - no foreign trade
no government
households and firms spend all their income and revenue
firms do not use financial markets (banks) to borrow money for investment

Question 7

the size of an economy (its national income or GDP), can be measured through…

Answer 7

the circular flow of income. The quantity produced must equal the level of expenditure by households, which must equal the amount paid to the factors of production.

Question 8

what is the formula for calculating an economy’s national income or GDP?

Answer 8

output of products = household expenditure = incomes of factors of production

O = E = Y

Question 9

what is O?

Answer 9

the value of the flow of goods and services from firms to households (expressed in real terms).

Question 10

what is E?

Answer 10

the value of spending by households on goods and services.

Question 11

what is Y?

Answer 11

the value of income paid by firms to households for their land labour and capital.

Question 12

what are the monetary ‘flows’ in the CFOI model?

Answer 12

expenditure and income

Question 13

what are the physical ‘flows’ in the CFOI model?

Answer 13

goods and services, and factor services

Question 14

what are leakages (W)?

Answer 14

factors that lead to income not being used for consumption in the circular flow.

Question 15

examples of leakages

Answer 15

savings (S) - where the household sets aside money for the future.
taxation (T) - where money is taken from households by the government.
imports (M) - where money leaves a country’s circular flow to buy other countries’ products.

Question 16

what are injections (J)?

Answer 16

factors that lead to additional income for firms, in excess of that received from consumption.

Question 17

examples of injections

Answer 17

investment (I) - where firms spend money on capital goods.
government spending (G) - where governments spend money on providing goods and services e.g. education.
exports (E) - where money enters a country's circular flow because other countries have bought its exports.

Question 18

what is macroeconomic equilibrium?

Answer 18

a state in which there is no tendency for national income to change.

If planned withdrawals exceed planned injections then on balance, money leaves the circular flow and so national income declines. In contrast, if planned injections exceed planned withdrawals, then more money enters the circular flow and so national income expands

Question 19

when does macroeconomic equilibrium occur?

Answer 19

planned injection (J) = planned leakage (W)

Question 20

income is either consumed or withdrawn hence…

Answer 20

Y = C + S + T + M

Question 21

what is disposable income?

Answer 21

the income that households have to devote to consumption and saving, taking into account payments of direct taxes and transfer payments.

Question 22

what is the average propensity to save (APS)?

Answer 22

the proportion of income that households devote to saving.

Question 23

what is the average propensity to consume (APC)?

Answer 23

the proportion of income that households devote to consumer expenditure.

Question 24

what does APS + APC equal to?

Answer 24

1

Question 25

what is the marginal propensity to consume (MPC)?

Answer 25

the proportion of additional income that households consume.

Question 26

what is the marginal propensity to save (MPS)?

Answer 26

the proportion of additional income that households save.

Question 27

what is the formula for marginal propensity to consume?

Answer 27

Δ in C / Δ in Y

Question 28

what is the formula for marginal propensity to withdraw?

Answer 28

Δ in W / Δ in Y

Question 29

what is the MPW made up of?

Answer 29

MPS + MPT + MPM

Question 30

as incomes increase, why does the MPW increase and the MPC decrease?

Answer 30

because people tend to devote a larger percentage of their income to savings and also tend to pay a higher proportion of their income as taxation.

Question 31

what is the multiplier effect?

Answer 31

the process by which any change in a component of AD results in a greater final change in real GDP.

Question 32

what is the formula for the multiplier effect?

Answer 32

1 / MPW = 1 / MPS + MPT +MPM

Question 33

if expenditure increases by £5 billion, and half of the income leaks out, what will be the final total

Answer 33

half of it must be MPW therefore multiplier =

1/0.5 = 2 so final total = £10 billion