how the macroeconomy works

Question 1

what are the injections into the circular flow of income?

Answer 1

• exports
• government spending
• investment

Question 2

what are the withdrawals to the circular flow of income?

Answer 2

• imports
• taxes
• savings

Question 3

what does it mean for the economy to be in equilibrium?

Answer 3

the injections equal the withdrawals

Question 4

what is the difference between nominal and real income?

Answer 4

• nominal income is the total amount of money a person earns in a given period of time
• real income is the nominal income adjusted for inflation

Question 5

what is a positive output gap?

Answer 5

when actual output is greater than potential output

Question 6

why does a positive output gap occur?

Answer 6

occurs when the economy is growing faster than the trend, it is trying to operate above its potential

Question 7

what are the problems with a positive output gap?

Answer 7

• leads to a shortage of raw materials and labour
• leading to a rise in production and labour costs
• therefore high inflation rates

Question 8

what is a negative output gap?

Answer 8

when actual output is less than potential output

Question 9

why does a negative output gap occur?

Answer 9

occurs when the economy is growing below the trend, there is likely to be spare capacity in the economy

Question 10

how does a positive output gap influence monetary policy?

Answer 10

a positive output gap is likely to persuade the MPC to raise interest rates to slow down the economy and reduce inflation

Question 11

how does a negative output gap influence monetary policy?

Answer 11

a negative output gap is likely to persuade the MPC to lower interest rates to speed up the economy and increase inflation

Question 12

what are the four main causes of unemployment?

Answer 12

• cyclical
• structural
• seasonal
• frictional

Question 13

what is cyclical unemployment?

Answer 13

• this is when the unemployment rate rises during an economic downturn and falls during a recovery
• it is caused by fluctuations in the business cycle

Question 14

why does employment increase in the recovery period of the economic cycle?

Answer 14

when the economy is in a boom period, consumers are spending and firms need more workers to increase production, because labour is a derived demand

Question 15

what is structural unemployment?

Answer 15

• this is caused by changes in the economy, like the decline of certain industries or the rise of automation
• it occurs when there is a mismatch between the skills of workers and the needs of employers

Question 16

what is frictional unemployment?

Answer 16

short-term unemployment caused by people transitioning between jobs, moving to a new location, or re-entering the workforce after a break

Question 17

what is seasonal unemployment?

Answer 17

arises due to fluctuations in the demand for labour throughout the year e.g. agriculture, tourism

Question 18

what is the formula for calculating real income?

Answer 18

real income = (nominal income / price index) x 100

Question 19

what is the relationship between income, output and expenditure in the circular flow of income model?

Answer 19

income = output = expenditure

Question 20

what is aggregate demand?

Answer 20

the total demand for all goods/services in an economy at any given average price level

Question 21

what are the components of aggregate demand?

Answer 21

• consumption
• investment
• government spending
• net exports (exports - imports)

Question 22

explain how interest rates affect aggregate demand

Answer 22

• an increase in interest rates
• means that the cost of borrowing is reduced
• this encourages more spending and investment in the economy
• consumption and investment are both components of AD
• therefore, an increase in consumption and investment increases AD

Question 23

what are the determinants of consumption?

Answer 23

• income tax/disposable income
• consumer confidence
• interest rates
• employment rates
• wealth effects

Question 24

what is investment?

Answer 24

spending by firms on factors of production to produce goods and services

Question 25

what are the determinants of investment?

Answer 25

- interest rates - business confidence - performance of the economy - foreign demand for exports - access to credit - government regulation

Question 26

what does the acronym SPICED stand for?

Answer 26

strong pound, imports cheaper, exports dearer

Question 27

what causes a shift in the AD curve?

Answer 27

changes in one of the AD components i.e. consumption, investment, government spending and net exports

Question 28

what is the multiplier effect?

Answer 28

the concept that an injection into the circular flow of income leads to a disproportionate increase in economic growth

Question 29

why is the AD curve downward sloping?

Answer 29

- lower prices in an economy increase global competitiveness, so exports increase and imports decrease - therefore, net exports are lower at higher prices, so AD decreases - at higher price levels, interest rates are likely to be raised by the MPC - therefore, the cost of borrowing increases and at higher prices, domestic consumption is lower as households can afford fewer goods and services, so AD decreases

Question 30

explain how interest rates affect consumption

Answer 30

- higher interest rates increase the cost of borrowing, and increase the benefit of saving - therefore, people borrow less and save more, so consumption falls - higher interest rates increase the cost of mortgages (higher mortgage interest repayments), reducing the amount of money consumers have to spend on goods and services, decreasing consumption

Question 31

explain how consumer confidence affects consumption

Answer 31

if consumers are confident, both in terms of job security and future income prospects, they will tend to spend more and also make large purchases which they can pay for in the future

Question 32

explain how house prices (the wealth effect) affects consumption

Answer 32

- if house prices increase, consumers could go to their mortgage provider and request more mortgage equity release (i.e. take out a loan based on the increased wealth) - this adds to the consumer's disposable income, so consumption therefore increases - if house prices increase, consumers feel more confident and 'wealthier', and therefore save less and spend more, increasing consumption

Question 33

explain how interest rates affect investment

Answer 33

- to invest in capital stock, firms have to borrow money to finance the investments - higher interest rates increase the cost of borrowing, and hence makes investment less attractive for firms - so with higher interest rates, investment falls

Question 34

what is aggregate supply?

Answer 34

the total amount of goods and services produced in an economy at a given price over a period of time