A-Level Economics A: THEME 2 GENERAL KNOWLEDGE Flashcards

Question

2.4.1 National income What does the circular flow of income suggest?

Answer 1

This model provides an illustration of the flow of money around an economy. Firms pay households for their factors of production (labour, land and capital) and households pay firms for goods and services.

Answer 2

- Households own the factors of production that firms need to produce goods and services, so firms pay households to use them. - Labour is paid for in wages. - Land is paid for in rent. - Capital is paid for in interest.

Answer 3

Income is a flow of money, often measured on a monthly or annual basis.

Answer 4

Wealth is the sum of all assets, including pensions, money in the bank, financial investments, and the value of a home.

Answer 5

- Taxation policy: regressive policies will tend to increase the income and wealth gap between different groups in a country. Progressive taxation policies will reduce the gap. - The differences in wage between low and high skilled labour. - The level of discrimination against different groups of workers. - Regional differences in earnings. - Unsalaried individuals depending on state benefits.

Answer 6

Withdrawals refer to flows of money leaving the circular flow of income.

Answer 7

- Savings - Taxes - Imports

Answer 8

Injections refer to flows of money into the circular flow of income.

Answer 9

- Exports - Investment - Government Spending

Answer 10

If injections exceed withdrawals, then the circular flow of income will expand. And so national income will rise.

Answer 11

If leakages exceed injections, then the circular flow of income will shrink. And so national income will fall.

Answer 12

If the government decides upon expansionary fiscal policy and increases government spending, this raises injections.

Answer 13

If injections exceed withdrawals, the circular flow of income will expand and national income will rise.

Answer 14

If there is uncertainty (low animal spirits), say, because of the risk of a break up of the European Union (EU), then consumers will save more (savings is a leakage) and firms will invest less (investment is an injection).

Answer 15

If leakages exceed injections, the circular flow of income will shrink and national income will too.

Answer 16

- The marginal propensity to consume (MPC) is calculated as the change in C divided by change in income. - The MPC represents the amount of each extra pound that the consumer spends when given an extra pound in income.

Answer 17

- The marginal propensity to save (MPS) is calculated as the change in savings divided by the change in income. - The MPS represents the amount of each extra pound that the consumer saves when given an extra pound in income.

Answer 18

- The marginal propensity to tax (MPT) is the change in tax paid divided by the change in income. - The MPT represents the amount of each extra pound earned that is spent paying taxes.

Answer 19

- The marginal propensity to import (MPM) is the change in imports purchased divided by the change in income. - For every extra £1 of income, the MPM is the proportion of that £1 spent on imported goods.

Answer 20

- Let's say a government decides to build a new hospital at a cost of £50 billion. - Government spending (G) will rise by £50bn. AD and real GDP will rise by £50bn. - The government will spend £25bn of this money on a construction firm. The firm spends £10bn on investment (I), a component of AD. Investment rises by £10bn. - The firm also spends £5bn on workers who receive higher incomes and spend this – so now consumer spending (C) goes up by £5bn. C is another component of AD. - AD has risen £65bn (£50bn plus £10bn plus £5bn) from an initial £50bn. - So, if spending rises by an initial £50bn, there will be one large rightwards shift in AD. But each stage of the multiplier effect could be viewed to add another small rightwards shift in AD, each of a smaller size than the last.

Answer 21

- Japelli (1990) found that 20% of the American population was credit-constrained. - Gross & Souleles (2002) found that 2/3 of people responded to automatic increases in their credit card limits by spending more.

Answer 22

- The marginal propensity to withdraw is the proportion of additional earnings that are taken out of the economy via savings, taxes paid to the government or imports from abroad. - The marginal propensity to withdraw = MPS + MPT + MPM.

Answer 23

- The MPS is the portion of extra income that is saved by an individual. - Savings are a withdrawal and cannot be spent on consumption. - A higher MPS will increase the MPW and reduce the size of the multiplier in the economy.

Answer 24

- The MPM is the portion of extra income that is spent by an individual paying for imports from overseas. - Imports are a withdrawal and cannot be spent on consumption. - A higher MPM will increase the MPW and reduce the size of the multiplier in the economy.

Answer 25

When economy is at its peak (the boom), national income is high and the economy is likely to be working above PPF where there is a positive output gap . Consumption and investment tend to be high as are tax revenues, and wages will be increasing. Usually, the country will increase imports to meet the demand of high-income consumers that cannot be met by the goods produced within the country. There will also be inflationary pressure.

Answer 26

When the economy is at the bottom of the cycle, it is in a slump, trough, depression or recession. There tends to be high unemployment causing low consumption, investment and imports. Inflationary pressure will be low and there may even be deflation. In the UK, the government defines recession as where real GDP falls in at least two successive quarters.

Answer 27

- Agricultural harvest - A bad harvest for an agricultural-based economy could trigger or prolong a recession. - Trading partners - A recession in the main trading partner e.g. a recession in the EU would cause exports to fall from the UK, which could trigger a change from slowdown to recession. - Global financial crisis - A global financial crisis e.g. 2008, could cause a boom to turn into a recession.

Answer 28

- Economic growth - Low unemployment - Stable inflation - Balance of payment equilibrium on the current account - Protection of the environment - Greater income equality

Answer 29

In the UK, the long run trend of economic growth is about 2.5%. Governments aim to have sustainable economic growth for the long run.

Answer 30

Governments aim to have as near to full employment as possible. They account for frictional unemployment by aiming for an unemployment rate of around 3%. The labour force should also be employed in productive work.

Answer 31

In the UK, the government target is 2%, measured by CPI. This aims to provide price stability for firms and consumers and will help them make decisions for the long run.

Answer 32

This is important to allow the country to sustainably finance the current account, which is important for long term growth.

Answer 33

- Demand-side policies are policies designed to manipulate consumer demand. - Expansionary policy is aimed at increasing AD to bring about growth, whilst deflationary policy attempts to decrease AD to control inflation.

Answer 34

- Monetary policy - where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy. - Fiscal policy - the use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance.

Answer 35

Interest rates are the cost of borrowing money. Interest rates are normally expressed as a % of the total borrowed.

Answer 36

- If the Bank Rate was lowered (the Bank Rate is the Central Bank interest rate, also sometimes known as the Base Rate), it should lead to a lower LIBOR (London Inter-bank Offered Rate). This is the rate at which commercial banks lend/borrow from each other. - They then pass this on (in theory!) to consumers/firms via a decrease in mortgage rates/loans. This then has effects on the various components of AD/AS.

Answer 37

- Mortgages become cheaper because the interest rate charged by banks falls. This allows first-time house buyers to take out more mortgages. The housing market booms. - As the housing market booms, existing homeowners experience a positive wealth effect because houses go up in value. They may take out larger mortgages giving them more to spend now (equity withdrawal effect). - Existing mortgage holders have lower monthly repayments so they may spend more elsewhere in the economy.

Answer 38

- Loans are cheaper. So people borrow more to finance consumption, especially consumer durables. AD rises, with ensuing positive multiplier effects. - The return on savings falls when the interest rate falls, and the opportunity cost of consuming falls, so can spend more.

Answer 39

- Lower corporate borrowing rates means that the government can borrow money at an even lower interest rate. - The government can borrow more cheaply, so running a fiscal deficit (spending > tax revenue) is less negative (or important) than when interest rates are high. - But in a booming economy, tax revenues may rise, making a fiscal budget deficit less likely.

Answer 40

- Lower interest rates means hot money (speculative money flows that chases the highest rate of return) flow out, which means there is an increased supply of sterling, and a fall in demand for sterling, causing the currency to depreciate. - This means imports become more expensive in domestic currency terms, exports become cheaper in foreign currency terms; ceteris paribus demand for M falls and X rises, so the value of X rises and M falls and the trade deficit falls, so AD rises.

Answer 41

- Loans are cheaper now, so easier to meet the hurdle rate of return projects. - This means more projects are undertaken, e.g. construction, so real GDP rises. Previously unprofitable projects now become profitable.

Answer 42

The Bank of England cut the interest rate from 5.74% to 5.5% to encourage consumers to spend and firms to invest (boosting AD).

Answer 43

The Bank of England continued cutting the interest rate until it reached 0.25% in August 2016.

Answer 44

As economic performance improved, unemployment fell and inflation pushed up, the Bank of England began raising the interest rate, to 0.5% in 2017 and to 0.75% in 2018.

Answer 45

The Bank of England began raising the interest rate, to 0.5% in 2017 and to 0.75% in 2018.

Answer 46

- The rise in interest rates will increase the cost of borrowing for firms and consumers. - This will lead to a fall in investment and consumption, reducing AD. - Two particular areas of consumption that will decrease are consumer durables and houses. Higher interest rates require higher rates of return for investment. - It also makes savings more attractive, as the interest earnt on them will be higher.

Answer 47

- Since fewer people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets. - Therefore, consumers will experience a negative wealth effect since the value of their assets fall, which will lead to a fall in consumption. - Moreover, investment is less attractive since firms are likely to see lower profits if prices fall. AD falls because of the fall in consumption and investment.

Answer 48

- People will become less confident about borrowing and spending if interest rates rise. - The fall in consumer and business confidence leads to a fall in consumption and investment, causing a fall in AD. On top of this, other loans, such as mortgages, will become more expensive to repay and so consumers have to dedicate more of their income to pay back these debts. - This means they have less income to spend on goods and services, so consumption will fall, causing AD to fall.

Answer 49

- Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return. - As a result, there will be increased demand for pounds and the value of the pound will rise. - This means that imports will be cheaper, and exports will be more expensive. This decreases net trade and therefore AD

Answer 50

- The exchange rate may be affected so exports fall and imports rise, causing a balance of trade deficit. - Changes in interest rates take up to 2 years to have their full effect and small changes may not affect people. - A lack of confidence in the economy may mean no matter how low the interest, consumers and businesses may still not want to borrow or banks may not want to lend them.

Answer 51

- Good news for borrowers, bad news for savers. Lower interest rates are bad news for savers. For example, retired people may live on their savings. If interest rates fall, they have lower disposable income and so will probably spend less. - However, lower interest rates should cause a depreciation in the exchange rate. This makes exports more competitive, and if demand is relatively elastic, the impact of a lower exchange rate should cause an improvement in the current account. Therefore, it is not certain how the current account will be affected. - A lack of confidence in the economy may mean no matter how low the interest, consumers and businesses may still not want to borrow or banks may not want to lend them.

Answer 52

This is when the Bank of England buys assets in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.

Answer 53

It can prevent the liquidity trap, where even low interest rates cannot stimulate AD.

Answer 54

- The Central Bank creates money electronically. (This is a similar effect to printing money, except they are increasing bank reserves which don’t need to be printed in the form of cash) - The Central Bank uses these extra reserves to buy various securities. These include government bond and corporate bonds.

Answer 55

- Increased liquidity. Banks sell assets (bonds) for cash. Therefore banks see an increase in their liquidity (cash reserves). In theory, the bank will then be more willing to lend to customers. This lending will be important for increasing investment and consumer spending. - Lower interest rates. Buying assets reduce their interest rate. Lower interest rates on these securities may also encourage banks to lend rather than keep securities which are paying low interest. Higher lending should help improve economic growth.

Answer 56

- Increase bank lending leading to higher investment. This should stimulate economic growth - Increase inflation. Quantitative easing may be pursued when there is underlying core-inflation close to 0%. 0% inflation and deflation can lead to lower spending and economic growth. Therefore, aiming for a higher inflation rate can encourage spending.

Answer 57

When monetary policy becomes ineffective because, despite zero/very low-interest rates, people want to hold cash rather than spend or buy illiquid assets.

Answer 58

Balance sheet recession. In a balance sheet recession, firms and consumers have high levels of debt and the recession creates an incentive for them to pay off debt (and cut back on borrowing). Whatever happens to interest rates, firms do not want to borrow – they want to pay off their debts so there is little appetite for higher spending.

Answer 59

- Preference for saving. Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don’t want to lend.

Answer 60

Inelastic demand for investment. In a liquidity trap, firms are not tempted by lower interest rates. Usually, lower interest rates make it more profitable to borrow and invest. However, in a recession, firms don’t want to invest because they expect low demand. Therefore, even though it may be cheap to borrow – they don’t want to risk making investment.

Answer 61

- For example, quantitative easing involves the Central Bank purchasing bonds from commercial banks. By selling bonds, the commercial banks see an increase in their cash balances. If the economy was growing strongly, they would have the confidence to lend these extra bank balances out to firms. This could cause inflation if demand grew faster than supply. - However, in a recession, when there is spare capacity and lower output, banks will not want to lend these extra money deposits. Firms will also be reluctant to borrow because they are not optimistic about the future.

Answer 62

Since the bank is buying assets, there is a rise in demand and so asset prices rise . This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption. Moreover, the cost of borrowing will decrease as higher asset prices mean lower yields (money earnt from assets), making it cheaper for households and businesses to finance spending.

Answer 63

The money supply increases . Private sector companies receive more money which they can spend on goods and services or other financial assets, which may increase investment or consumption and therefore increase AD. It may also push asset prices up further. Banks have higher reserves, meaning they can increase their lending to households and businesses so both consumption and investment increase as people can buy on credit.

Answer 64

Commercial banks may lower their interest rates as they are receiving so much money from the Bank of England and so can offer very low interest deals to their customers. The increased money supply will mean that the price of money falls; interest rates are the price of money. This will encourage borrowing, and therefore increase investment and consumption so increase AD. If many banks decide to lower their interest rates, the same mechanisms will apply as those following a reduction in the base rate.

Answer 65

- If not controlled properly, could cause hyperinflation. - Others say it would only lead to increased demand for second hand goods which pushes up prices but does not increase aggregate demand. For example, it would not lead to more new houses being built but only second hand houses becoming more expensive. - There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.

Answer 66

Monetary policy is controlled by the Bank of England rather than the government. The Monetary Policy Committee (MPC) makes the most important decisions, including the Bank of England base rate and the actions over quantitative easing.

Answer 67

Their main aim is to keep inflation at 2% and if it goes below 1% or above 3% the governor of the Bank of England has to write a letter to the Chancellor of the Exchequer explaining why this is happening and what the Bank of England is doing to bring it back to the target. They use CPI in order to see whether this target has been met.

Answer 68

The Committee is made up of nine people: five are from the Bank of England, including the Governor of the Bank of England, and the other four are independent outside experts, mainly economists.

A-Level Economics A: THEME 2 GENERAL KNOWLEDGE Flashcards

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