National income 2.4 Flashcards
What are the characteristics of households, money, goods/services, and factors of production in a two-sector economy?
Households own all the wealth and resources so provide the firms with land, labour and capital in return for rent, wages, interest and profits. They use this money to buy goods and services produced by the firms.
Money flows in one direction and goods, services and factors of production flow in another.
How is economic activity measured in the two-sector economy?
National output is measured by the value of goods and services from firms to househoulds.
National expenditure is measured by the value of spending by households on goods and services.
National income is measured by the income paid by firms in return for factors of production i.e. land, labour, capital and enterprise.
National output = national expenditure = national income.
Why is the two-sector model too simplified to represent the actual economy?
(3 reasons).
-Firstly, the government needs to be added as they take money out of the economy through taxation (T) and add money through spending (G). The flow of income can be increased if the government spends more than it takes away.
-Secondly, financial services needs to be included as they can inject money into the system through investment (I) and take money away when consumers or producers save (S).
-Finally, foreign markets needs to be added as foreigners buy British goods so exports (X) add money to the flow of income but British people also want to buy goods so imports (M) take away from the the flow.
What is the difference between wealth and income?
Wealth is a stock of assets whilst income is a flow.
If the sum of injections (G I X) is greater than the sum of leakages (T S M) then the economy will be…
growing.
If the sum of injections (G I X) is less than the sum of leakages (T S M) then the economy will be…
shrinking.
The equilibrium position of national output is where…
the AD and AS curves intersect.
What happens when there is an outwards/inwards shift of AD in the classical LRAS curve and why?
As the classical LRAS curve is perfectly inelastic (i.e. a change in price has no effect on the change in output), a shift of the AD curve would not affect the long run national output and would only affect price levels. This is because classical economists believe that the economy will always return to the full employment level and therefore there will be no unemployment in the long run.
Using a diagram, explain how (according to classical economists) the economy will always return to full employment level.
An increase in AD1 to AD2 leads to a positive output gap. The economy is in long term disequilibrium as SRAS 1 and AD2 do not intersect on the LRAS
curve. The short-term equilibrium is P2Y2. The means that there is over-full employment and firms will end of bidding up wages of labour (firms that offer a higher salary attract the best workers).
As a result, SRAS shift to SRAS2 as the cost of production has increased, they are producing at Y1P3.
The short run equilibrium has now shifted and is now as the same as the long run equilibrium. Therefore, according to classical economists the economy will always return to full employment and therefore there will be no unemployment in the long run.
Classical economists conclude that an increase in AD will increase the price and output in the short run but over time, prices will continue to rise as the economy moves back to the long-term equilibrium.
What does this mean?
This means that output has not changed, so a change in AD without a change in LRAS is purely inflationary. Therefore, the only way to increase output is by increasing LRAS.
Why do classical economists favour supply-side policies over demand management?
A rise in LRAS is likely to lead to lower prices and higher outputs. However, a rise in AD is causes an increase in prices and no higher output.
What is it that Keynesian economists believe that classical economists don’t?
Keynesian economists believe there can be equilibrium at less than full employment (where the curve is horizontal). This is because they don’t believe a rise in unemployment rapidly leads to a a fall in wages.
What is the idea of multiplier process?
The multiplier process is the idea than an increase in AD because of an increased injection (exports, government spending or investment) can lead to a further increase in national income.
Define the multiplier process in the context of a ratio.
It is the ratio of the final change in income to the initial change in injection.
It is also the figure multiplied by the original injection to find the final change in income.
What is the size of the multiplier determined by?
The size of the multiplier is determined by how much of an increase in income people will spend (MPC). The the lower the leakages, the higher the MPC, the bigger the multiplier.
What is occurring from AD1 to AD2?
From AD1 to AD1, there is only an increase in output and not price, this happens when the economy is a in a deep recessions. The equilibrium changes from P1Y1 to P1Y2.
With a Keynesian curve, explain how the impact of a shift in AD strongly depends on the elasticity of the curve?
Therefore, this is why Keynesians argue that…
If the economy is producing near full employment, for example at AD1, then a rise in LRAS will increase the output and decrease the price level. This is seen by a change in equilibrium from P1Y1 to P2Y2 following the shift.
However, if the economy is in a deep recession, for example producing at AD2. then an increase in LRAS will have no effect on prices or output. This is shown by the fact that the equilibrium is still at P3Y3.
Therefore, this is why that during recessions the government needs to work to increase AD rather than using supply side policies.
