Macro exam prep Flashcards
(10 cards)
Circular flow of income model + draw diagram
A simple visual model that demonstrates how money flows through an economy, it shows how households and firms interact, how money is generated spent and redistributed
It’s 2 main flows are income (y) generated from services e.g rent or labour and expenditure(e) which is the generated capital spent on goods and services
As observable, when Y passes through domestic households it become consumption demand + withdrawals and when expenditure passes through domestic firms it become consumption demand + injections. Thus when Y = E, W = J
At the same time our model also highlights withdrawals and injections. Withdrawals are formed of saving, taxes and imported goods highlights money leaving the flow. If at any point withdrawals are higher than injections it will reduce national income and slow the economy. Injections are formed of Investment, government expenditure and exported goods and highlight the entrance of money into the flow. If injections are at any point higher than withdrawals then national income will increase and economic output should be stimulated.
For the economy to achieve equilibrium these 2 factors must be balanced. Where W = J .
The model can be used to look at flows, to observe economic activity and observe policy impact. It helps identify how economies interact with global markets (using exports and imports) and identify where fiscal and monetary policies can be implemented to sabalise of grow income.
The withdrawals and injections model (WJ model) + draw diagram
what is the model
what does it show
what is it used for
what does it connect to
The WJ model builds on the circular flow model by explaining national income, looking at the balance between injections and withdrawals that occurs at short run economic equilibrium.
It shows that when withdrawals exceed injections the national income will fall and when injections exceed withdrawals national income will rise until a new equilibrium is established where W = J
This model is commonly used to look at the impacts of fiscal policy on short run output by demonstrating how changes in injections and withdrawals can influence national income.
It also demonstrates the multiplier effect showing how initial injections can have amplified effects on national income
In cases like an increase in tax rates or savings rate the Withdrawals line could pivot upwards.
Visually the model has an y axis: W,J and an X axis, Y(national income). It has a fixed horizontal injections line and an upwards sloping withdrawals line. When these shift we can observes changes to national income in the economy.
Keynesian cross model + draw diagram
what does it build on
what does it consider
where do = occur
what does it demonstrate and link to
draw diagram
The keyensian cross (KC-cross) model builds on the circular flow model and considers the impacts of fiscal policy on short run equilibrium output which occurs where Y = AE. E = C + J thus E = C + I + G + X - IM. The model demonstrates how fiscal policy impacts national income and how expansionary fiscal policy can have a multiplied impact on output when there is spare output in the economy.
In the KC cross diagram our Y axis is expenditure, our x axis is Y our 45 degree line is also represented by and our expenditure is upwards sloping (the slope determined by the MPC) and intersects with the Y at some point on the graph to indicate equilibrium.
A rise in I, G, X or Consumption or a Fall in S, T, IM will shift E upwards
A fall in I, G, X or consumption or a rise in S, T, IM will shift E downwards. Can use graphical drawing to explore impacts on Y and E firther.
Explain the quantity of money theory + diagram
intro
explain theory
monterist view
kenesian critique
MV = PT or MV = PY - this is a monetarist theory which explains the relationship between money supply and price level in the economy justifying the use of monetary policy especially for controlling inflation where:
M = money supply
V = Velocity of money
P = Price level
T = transaction volume/ Y = output/gdp
The left side = total money spent in the economy
The right side = The total value of goods and services sold
It demonstrates how money supply drives inflation as v is assumed to be stable and Y is determined by real factors any increases in money supply (M) will proportionally increase price level (P). Therefore monetary policy is essential for controlling inflation.
Monetarists argue against fiscal policy, it is too slow and politically influenced whereas monetary policy can be directly implemented by central banks to control money supply, influence interest rates and stabalise inflation an expectations.
The keynesian critique is that velocity is not always stable and increasing money supply in a recession may not be effective in instances of liquidity traps. Thus saying in the short run monetary policy is ineffective especially in recesions due to factors such as time lags and interest inelastic investment.
The Y axis - price level
THe x axis - GDP/Y
LRAS vertical - represents economies max output
AS - normal supply curve
AD - normal demand curve, will shift if the money supply increases or decrease
Explain equilibrium in money markets + diagram
-what is money supply determined by
-who determines it how is it set
money demand -
where does = occur
In the money market supply and demand determine the interest rates. The money supply is controlled by central banks and is fixed/ exogenously set in the short run - this means the money supply is determined by factors outside the model and cannot be impacted by factors from within the model. we assume it to be constant in the context of the model
Money demand consists of transactionary demand, demand for money used for day to day activities. Speculative demand - money used for taking advantage of investment opportunities. And precautionary demand, demand for money used in cases of emergency or unforeseen events.
Equilibrium occurs when money supply = money demand Ms = Md
The model to graphically depict this at a basic level = IS/LM model.
Y axis - real interest rate
X axis - GDP/Y/output
LM curve = supply curve
IS curve = Demand curve
describe what happens when the price level increases - underneath the framework of the IS/LM model
intro
explain model
apply and diagram
conclusion
IS/LM model + diagram.
The IS/LM model graphically illustrates the interaction between the goods market(IS) and the money market(LM), THe interaction of thsee curves determine equilibrium levels of national income and interest rates. A rise in prices would reduce real money supply triggering a shift in the LM curve and affecting national income and interest rates.
In the IS/LM model the IS curve represents equilibrium in the goods market by showing all combinations of interest rates and national output where the goods market is in equilibrium. This is where total output = aggregate demand
: Y = C + I + G + X
As investment is inversely related to interest rates, A lower interest rates will encourage investment, this will raise aggregate demand and output explaining the curves downward sloping nature.
In the IS/LM model rhe LM curve represents equilibrium in the money market by showing every combination of national income and interest rates where the money market is in equilibrium. This is where money demand = money supply. Real money supply = m/p m = nominal money supply p = price level.
If income rises at a given level of money supply, money demand will also rise, specifficallly transactionary, speculative and precautionary demand for money. This will cause a rise in interest rates as a response to excess demand to bring the market back to equilibrium explaining the curve’s upwards sloping nature.
When prices rise or money demand changes the lm is susceptible to shifting, when aggregate demand changes the IS curve becomes susceptible to shifting.
To conclude, as seen in the diagram a rise in prices causes the lm curve to shift towards the left. This causes interest rates to rise and equilibrium national income to fall overall demonstrating the contractionary effects of inflation.
Keynesian view, inelastic IS curve. Flat/elastic ms supply curve. Any fiscal stimulus derived from tax suits or increased government expenditure that increases national income will shift the IS curve right.
If we maintain a keynesian view and consider a monetary stimulus we would be able to observe monetary policies innefectiveness when IS is inelastic. The rightwards shift of the MS curve woul lead to a small change in Y after lowering R rather than fiscal policies larger change substantiated by the expansionary fiscal policy.
Monetarist view. They believe the opposite that the LM curve is inelastic and the IS curve is flat thus in the face of fiscal policy it becomes wholly ineffective at stimulating increases in output when shifted to the right.
Maintaining this perspective and observing the changes when monetary policy is immplemented, we see that when the curve is shifted to the right (due to expansionary monetary policy) that we have a large increase in output derived from an incremental decrease in R. thus providing an argument for the implementation of monetary policy over fiscal policy.
X axis - y - national income
y axis - r - interest rates
The LM curve shifts if there is a change in real money supply or a change in money demand
Explain the multiplier effect.
- what models is it relevant to
- what does it show what does it help explain
- what can it be amplified by
- formula
- when does it fail to stimulate economic growth
Relevant to the kc-cross model and the wj model
The multiplier effect refers to a situation where the initial injection into the economy leads to a greater overall increase in economic output (Y). The multiplier is the ratio of the change in y and the initial injection and helps explain why fiscal stimulus can lead to a proportionately larger change in output
The multiplier effect occurs because as money circulates through the economy each recipient spends a portion of what they received from the injection, this generates further rounds of income and spending.
This effect can be amplified by the MPC or weakened by the MPW. MPC refers to the likeliness people to spend the additional income they earn, the MPW refers to the likeliness of additional income going to wards taxes, saving or imported goods and thus is money leaving the economy.
The MPW and MPC are impacted by real world factors like economic conditions, income levels and consumer confidence.
Base formula k = 1/mpw = 1/(mps + mpt + mpm) = 1/1 - mpc
However if the economy is close to full capacity this effect will cause inflation and not economic growth
The accelerator effect:
Transmission mechanism:
The accelerator effect explains how investment responds to shifts in national income. Investment is the most volatile component of aggregate demand impacted by expectations, business confidence and income. Small changes in these can trigger big changes to investment amplifying economic fluctuations creating a more volatile economic environment.
- Relevant to kc-cross model and wj model
The transmission mechanism refers to the process of interest rate changes, monetary policy implemented by central banks, affecting the macroeconomy.
It has 3 stages:
1: monetary policy changing the interest rates
2: The changes affecting consumer and business behaviour e.g spending saving and investment
3: The shifts impacting aggregate demand, GDP and inflation
The transmission mechanism helps explain how monetary policy can manage economic activity and stabalise inflation. however it is limited when due to time lags, and in recessions where consumer confidence is low and liquidity traps can inhibit its effectiveness.
- relevant to the is/lm model.
Deflationary gap:
Inflationary gap:
Deflationary gap occurs when GDP is below potential output. this indicates a lack of aggregate demand. the gap represents inefficiencies like unemployment. The lack of demand causes downwards pressure on wages - as suppliers want to lower costs and downward pressure on prices to attract more sales. this is deflation. Policy makers often respond with fiscal and monetary expansionary policies to boost demand and bring the economy closer to potential output.
Inflationary gap occurs when actual output exceeds potential output meaning demand is higher than capacity. This creates inflationary pressures on prices and businesses charge more for the demand and workers demand higher wages for the higher prices. Contractionary monetary and fiscal polices are implemented to reduce aggregate demand and match it closer to potential output stabilising inflation.
both models can be used for kc cross model and ad-as questions. - by adding a full employment of potential gdp vertical line
Exogenous Growth model -
2 ways a country can achieve long term growth
intro
explain model
apply - 2 ways of acheiving growth
conclusion
2 limitations of the model:
Exogenous growth theory explains long term economic growth resulting from factors outside of the model (exogenous variables) and exogenous variable is one determined outside the model, the model doesnt explain the variable and it is taken as fixed underneath the models analysis. E.g technological progress and population growth. In contrast to short term models that focus on demand side fluctuations exogenous growth theory focus on supply side drivers of growth - how an economy can grow through capital accumulation and productivity improvements.
The model asserts the economy eventually reaches a steady state where capital stock per worker is constant - This occurs where the rate of investment balances with depreciation and growth rate of the labour force. Once the economy has reached this state growth rate can only be driven by technological progress and we find economic equilibrium.
The model assumes a production function:
Y = F(K,L,A)
Where Y = income, K = capital, L = labour and A = technological productivity.
The model shows that increasing capital per worker leads to short run economic growth but due to the law of diminishing marginal returns only technological progress can sustain long run growth.
Long run growth is determined by - technological progress, labour force growth and saviongs and investment (only happens before the economy reaches a steady state).
1st method of achieving long term growth is increasing the productivity of labour and capital. In the model this shifts the production function upwards allowing for higher output at the same capital level. For example advancements in Ai or a technological production enhancement that improves efficiency allows for sustained growth in GDP
Another method of achieving long term economic growth is population growth. Concerning labour force, increasing the population enables greater total output. If supported by adequate technology and capital the expanding workforce can contribute to long term GDP growth. One example could be india who benefits from a growing population and thus a growing pool of workers leading to long term GDP growth.
Y axis - output per worker (Y)
X axis - Capital per worker (K)
then has an output, investment and depreciation curve
To summarise the solow swan growth model shows a country can achieve long term growth through external factors such as technological advancements and labour force growth. Capital accumulation is only able to stimulate short term growth before the economy reaches a steady state.
2 limitations:
First is that the model treats technological progress as exogenous. It offers no explanation as too how innovation is created or influenced meaning we do not develop understanding of how domestic choices from governments e.g tax incentives, investment e.g research and development and education can boost or slow long term growth.
The second is that it assumes all economies will perform the same and catch up to each othe, however form observing reality we can see poorer countries do not often catchup to more developed ones. Often struggling due to differences in education, governance and labor skill.
