Circular Flow of Income

Question 1

What is the Circular Flow of Income?

Answer 1

A simple model of the process of which income and spending flows in an economy

Question 2

Who are the two main economic agents in the Circular Flow of Income?

Answer 2

Firms and Households

Question 3

What do households provide in the circular flow of income?

Answer 3

Factors of Production

Question 4

What do firms provide in the circular flow of income?

Answer 4

Goods and Services

Question 5

What are the factor rewards [incomes]?

Answer 5

1. Wages/Salaries
2. Profits
3. Rent
4. Interest

Question 6

What are the leakages in the Circular Flow of Income?

Answer 6

1. Savings
2. Taxation
3. Imports

Question 7

What are the injections in the Circular Flow of Income?

Answer 7

1. Government
2. Investment
3. Exports

Question 8

How do you show if the economy is growing or not through the circular flow of income?

Answer 8

Compare the leakages with injections

1. Leakages > Injections : more money is exiting the economy, low growth
2. Leakages < Injections : more money enters the economy, higher growth
3. Leakages = Injections : macroeconomic equilibirum ; growth neither increases or decreases

Question 9

Define GDP

Answer 9

A measure of economic growth in terms of gross domestic product, which is the total value of goods and services produced in an economy in a year

Question 10

What are the measures of GDP?

Answer 10

1. Output Method [Final Product]
2. Income Method [Factor incomes]
3. Expenditure Methods [Consumer spending]

Question 11

What is the Average Propensity to Consume and how is it Calculated?

Answer 11

The proportion of income which is consumed

Calculation : C / Y

C : Consumer , Y : Income

Question 12

What is the Marginal Propensity to Consume and how is it Calculated?

Answer 12

It refers to the proportion change in consumption for every one extra unit change in income

Calculation: Change in C / Change in Y

Question 13

What is the Average Propensity to Save and how is it Calculated?

Answer 13

The proportion of income which is saved

Calculation : S / Y

Question 14

What is the Marginal Propensity to Save?

Answer 14

The proportion change in savings for every one extra unit change in income

Calculation : Change is S / Change in Y

Question 15

What is the Marginal Propensity in a 2 Sector Economy?

Answer 15

MPC + MPS = 1

Question 16

What is the Marginal Propensity to Import and how is it calculated?

Answer 16

The proportion change in income spent on imports

Calculation : Change in M / Change in Y

Question 17

What is Average Rate of Tax and Marginal Rate of Tax?

Answer 17

Average rate of tax is the proportion of income which is taxed,

Marginal rate of tax is the proportion change in tax for every extra unit change of income

T / Y , Change in T / Change in Y

Question 18

What is the Keynesian Multiplier Effect?

Answer 18

A change in one of the components of AD leads to a multiplied final change in the equilibirum level of GDP

“one persons spending is anothers income”

Question 19

What is the formula for the Multiplier Effect?

Answer 19

1 / MPW or 1 / 1 - MPC

MPW : sum of propensities to save, tax and import

Question 20

Explain the Multiplier Effect

Answer 20

The injections into the economy, through government spending, stimulate an increase in AD which increases consumption and investment through new demand for goods and services, which stimulates further rounds of spending leading to a larger final effect on output and total employment

Question 21

What can be concluded by the Keynesian Multiplier Effect?

Answer 21

Higher the MPC, larger the multiplier effect

Question 22

What is the Negative Multiplier Effect?

Answer 22

When an initial decrease in injections [or increase in leakages] leads to a larger fall in final national output

Question 23

How is a Negative Multiplier linked to a Reccession?

Answer 23

It can deepen a recession by causing a larger fall in GDP than the initial shock, as the MPW increases.

Question 24

What are some Evaluation Points to consider about the Multiplier?

Answer 24

1. Output gaps / Capacity in the Economy
2. Interest rates and inflation
3. MPW vs MPC

Question 25

What is the basic form of the consumption function?

Answer 25

C = a + bY a = Autonomous Consumption b = MPC bY = Induced Consumption | [The relationship between consumption and income]

Question 26

Differentiate between Autonomous Consumption and Induced Consumption

Answer 26

Autonomous consumption is independent of income, while induced consumption may be influenced by income

Question 27

What increases the consumption function in AD?

Answer 27

1. Increase in real disposable incomes 2. Availability of Credit / Interest Rates 3. Consumer Confidence [Job prospects and Level of Unemployment] 4. Asset Prices [Wealth & Income]

Question 28

What is the basic form of the Savings Function?

Answer 28

S = -a + sY

Question 29

What is Autonomous Savings?

Answer 29

Savings where income is 0, or usually negative as prior savings have been used

Question 30

Why is the Savings Function important for an Economy?

Answer 30

It provides funds for the use of investment which drives LR growth

Question 31

Differentiate between Autonomous and Induced Investment

Answer 31

Autonomous Investment is that independent of income or output Induced investment is dependant of income and is illustrated by the movement of the expenditure line

Question 32

What is the Accelerator Effect?

Answer 32

Changes in investment can be directly linked to the changes in the rate of GDP growth

Question 33

What can be concluded by the Accelerator Effect?

Answer 33

When rate of GDP growth is increasing, more firms are willing to invest due to increased demand and growth in the future, vice versa

Question 34

What is some Evaluation of the Accelerator Theory?

Answer 34

1. If the economy has spare capacity or not 2. If capital good industries are working close to full employment

Question 35

What is a Negative Output Gap? [Deflationary / Reccessionary Gap]

Answer 35

A shortage of aggregate expenditure that potential output is not reached [actual level of output is less than potential output]

Question 36

What is a Positive Output Gap? [Inflationary Gap]

Answer 36

Excess of aggregate expenditure over potential output [actual output is greater than potential output]

Question 37

What can be critiqued from output gaps?

Answer 37

A negative output gap can be fixed through increased government spending to stimulate AD - there may not necessarily be inflation as the economy is not close to YFE.