Theme 2 Topic 4

Question 1

What is the circular flow of income ?

Answer 1

An economic model showing the flow of goods and services, the factors of production, and their payments between households and firms within an economy.

Question 2

What does the simple model show ?

Answer 2

The UK economy is complex and operates in a global environment.

The model is simplified for analysis.

Assumptions:
- The economy is “closed” (no foreign trade or government influence).
- There are two main groups: firms and households.

Question 3

What does the circular flow of income show ?

Answer 3

Flow of money:

• Households (owners of factors of production) purchase goods and services from firms.
• Money flows back to households in the form of wages, rent, interest, and profit.

Question 4

what does national output equal ?

Answer 4

national expenditure = national income

Question 5

what are the 4 stages of the circular flow of income ?

Answer 5

1)Firms provide households with goods and services

2) Households spend their income on the goods and services produced by firms

3) Households also provide firms with factors of production: CELL

4) In order to pay for these factor services, firms pay households rent, wages, interest and profit

Question 6

How does GDP influence the flow of income ?

Answer 6

The more households spend the more firms produce. Demand drives supply.
Income and output should always have the same value in a closed model
We measure income/output using GDP

Question 7

land labour capital :

Answer 7

buildings, output, investment

Question 8

rent, wages, interest, profit

Answer 8

land, labour, capital, entrepreneurship

Question 9

what are the 4 assumptions that cause the model to be unrealistic ?

Answer 9

1. Households spend all their income on goods
   and services
2. Firms spend all their income on factors of
   production
3. There is no government
4. There is no foreign trade

Question 10

what is the correlation between income and wealth ?

Answer 10

wealth is a stock concept.

income is a flow concept.

as income flows from the stock of assets a nation’s income and wealth are directly correlated

Question 11

how is wealth a stock concept ?

Answer 11

assets owned (e.g. buildings, land)

human wealth (e.g. skills, education)

Question 12

how is income a flow concept ?

Answer 12

money generated from wealth (e.g. wages, rent, interest)

Question 13

income + wealth correlation :

Answer 13

Higher income can increase wealth, which helps fund investment.
Investment grows a country’s productive capacity (e.g. more machines and buildings).
This leads to long-term economic growth and higher future income.
More income in the future means more wealth and more investment.
There’s a trade-off: investing now means less consumption today but more income later.

Question 14

what are the 3 injections ?

Answer 14

1. Investment (increase in capital stock)
2. Government spending
3. Export purchases

Question 15

what are the 3 leakages ?

Answer 15

1. Savings
2. Taxation
3. Import purchases

Question 16

how is the flow of income link shown on the PPF curve ?

Answer 16

-There is a trade-off between using our income for consumption today and consumption for future generations
- If we use our income to invest in capital goods today it means that we are increasing our productive capacity
• This means that we have a greater stock of wealth
• An increase in capital goods will shift the PPF outwards
• This economic growth will lead to higher income in the future

Question 17

Why do we consider injections and withdrawals ?

Answer 17

To take into account a more realistic role of all the participants in the circular flow.

Question 18

How are injections + withdrawals shown on the circular flow of income diagram.

Answer 18

Injections go in

Withdrawals go out

Question 19

What are injections ?

Answer 19

Monetary additions to the economy.

Question 20

What are leakages ?

Answer 20

Money is removed from the economy

Question 21

injection greater than leakage :

Answer 21

economy grows

Question 22

injection less than leakage :

Answer 22

economy shrinks

Question 23

injection in equilibrium with leakage :

Answer 23

national income remains the same

Question 24

What is the macro economic equilibrium ?

Answer 24

Demand side and supply side of the economy are equal.
Everything produced by firms has been consumed by households.
No excess supply or demand.

Question 25

What does the size of the AS/AD shift depend on ?

Answer 25

The size of the shift The elasticity of the curve (which hasn’t been moved) e.g. the elasticity of AS if AD has been moved. if AS or AD shifts, equilibrium changes position.

Question 26

short term :

Answer 26

both classical and keynesian economists agree that AD will be downward sloping and AS will be upward sloping.

Question 27

Keynesian :

Answer 27

support economic policies that improve and manage AD. if the economy is operating below its full potential (e.g. recession), they would focus attention on policies that stimulate the components of AD.

Question 28

Keynesian graph :

Answer 28

there is full employment where the LRAS curve is vertical. however, there can be equilibrium at less than full employment where the curve is horizontal. this is because they don’t believe that a rise in unemployment rapidly leads to a fall in wages. unemployment occurs due to a deficiency of AD.

Question 29

long term AS :

Answer 29

- Economy is in equilibrium where **AS = AD** (Aggregate Supply = Aggregate Demand). - Supports economic policies that improve **LRAS** (Long-Run Aggregate Supply). - If **AD increases** without improving factor resources (quality/quantity), **inflation** occurs, which harms economic growth. - **LRAS curve** is perfectly inelastic: - A shift in AD **doesn’t affect national output** in the long run. - Only affects **price levels**. - Belief: The economy will always **return to full employment** in the long run, so **no unemployment** in the long run.

Question 30

increase in AD (LRAS) :

Answer 30

- **Positive Output Gap**: The economy is producing above its potential, leading to **over full employment**. - **SRAS shifts left**: As firms compete for labor, they **bid up wages**, increasing costs. - **Higher wages**: Firms offer higher salaries to attract the best workers, causing **costs to rise**. - **Result**: The economy produces the same output but at higher prices, shifting **SRAS left** until it aligns with **LRAS**. - **Short-run impact**: Increase in both **price** and **output**. - Over time, prices will continue to rise as the economy moves back to long-term equilibrium. - **Output doesn’t change** in the long run; to increase output, **LRAS** must increase. - **Changes in AD** without changes in **LRAS** lead to **inflation**.

Question 31

shift in LRAS to the right :

Answer 31

causes lower prices and a higher output. classicists economists favour supply side policies over demand management due to this. SRAS and AD don’t intersect so it will be closed by a shift in SRAS.

Question 32

Keynesian increase in AD from AD-AD1:

Answer 32

shifts right. expansion along LRAS curve. price level increases to P1. economy gets closer to full employment and resources are becoming more scarce. output increases to Y1, but spare capacity of Y1-FE remains.

Question 33

Keynesian increase in AD from AD1-AD2 :

Answer 33

if AD continues to increase without any increases in LRAS, at some point FE equilibrium will be reached, and any increases in AD above AD2 will be purely inflationary.

Question 34

Keynesian AD - AD3 to AD4 (lower point on curve):

Answer 34

if AD is at AD3 and shifts right to AD4, price level would be unchanged as there remains spare capacity in the economy. increases in AD can be absorbed without increases in the price level. any policies to increase LRAS would enhance spare capacity and leave the equilibrium level of employment unchanged.

Question 35

Keynesian LRAS shift right :

Answer 35

caused by an increase in capital efficiency. there would be an expansion along the AD curve. price level decreases (as available factor resources are increased and scarcity decreases). real national output increases to Y1 and maximum productive potential increases to FE1. this indicates economic growth.

Question 36

What does the impact of a shift in AD depend on ?

Answer 36

the elasticity of the curve. and whether the economy is at or near full employment

Question 37

what do Keynesians argue should happen during recessions ?

Answer 37

the government needs to work to increase AD rather than using supply side policies.

Question 38

increasing AD and AS :

Answer 38

•Increased AD (e.g., investment) raises demand for goods and services. • Short-run effect: • The economy can't immediately meet this higher demand. • This causes temporary disequilibrium, where demand exceeds supply and prices rise (inflation). • Investment boosts LRAS: • New investments (like machinery or technology) increase the economy's capacity to produce goods. • This shifts Long-Run Aggregate Supply (LAS) to the right, meaning the economy can produce more without facing capacity limits. • Long-run effect: •With increased LAS, the economy can handle higher demand without causing inflation. The economy reaches long-run equilibrium where output increases and prices stay stable. The efficiency of this concept depends on the rate of return on investment (whether it affects supply or not)

Question 39

what is the multiplier effect ?

Answer 39

occurs when an initial injection into the economy (or a circular flow of income) causes a larger final increase in the level of real national output. this is due to an increase in AD. one person’s spending is another person’s income

Question 40

multiplier effect’s impact on AD :

Answer 40

targeting individuals with a high MPC can boost AD in times of low demand.

Question 41

what is the multiplier ratio ?

Answer 41

ratio of the total change in income to the initial change in injection.

Question 42

formula for multiplier :

Answer 42

multiplier = 1/1-MPC if MPC = 0.9, the multiplier is 10. 1 represents 100% of the extra pound being spent.

Question 43

what happens if there is a higher MPC and low leakages.

Answer 43

the larger the multiplier (people spend more of their income). the government can stimulate demand more effectively by focusing on individuals who spend most of their income.

Question 44

multiplier size in developing + developed countries :

Answer 44

developed = around 1.5 developing = around 1.6

Question 45

negative multiplier :

Answer 45

due to withdrawals (e.g. tax hikes, reduced government spending), which causes a decline in AD and further reductions in income. causes slower economic growth.

Question 46

what is MPC ?

Answer 46

proportion of any change in income that is spent on consumption rather than saved. it drives consumption.

Question 47

what is MPW ?

Answer 47

marginal propensity to withdraw. the total increase in leakages in the economy, reducing the multiplier effect.

Question 48

MPW formula :

Answer 48

MPW = MPS + MPT + MPM an increase in either one reduces MPC and weakens the multiplier effect.

Question 49

what is MPS ?

Answer 49

marginal propensity to save. the proportion of income saved rather than consumed. a higher MPS means there is reduced spending and lowers the multiplier.

Question 50

what is MPT ?

Answer 50

marginal propensity to tax. the proportion of income taxed. higher taxes decrease disposable income, decreasing consumption and lowering the multiplier.

Question 51

what is MPM ?

Answer 51

marginal propensity to import. the proportion of additional income spent on imports. higher imports decrease domestic spending and lowers the multiplier.

Question 52

3 factors affecting MPC ?

Answer 52

1. interest rates 2. Taxes 3. Imports Multiplier size is sensitive to these factors.

Question 53

What does the multiplier size equal ?

Answer 53

1/1-MPC = 1/MPW

Question 54

Factors affecting MPC - interest rates

Answer 54

Increased rates encourage saving over spending, so MPC falls.

Question 55

Factors affecting MPC - taxes

Answer 55

Higher taxes (MPT) decreases disposable income and consumption, decreasing MPC.

Question 56

Factors affecting MPC - imports

Answer 56

Increased spending on imports (increased MPM) reduces domestic consumption, lowering MPC.

Question 57

2 effects of the multiplier on the economy :

Answer 57

1. Dynamic economy 2. Measuring the multiplier

Question 58

Dynamic economy :

Answer 58

The multiplier is influenced by variables such as : Spare capacity : if it’s low, firms can’t meet higher demand, limiting the multiplier’s effect. Unemployment : higher unemployment allows firms to expand and boost AD more effectively. Inflation and the exchange rate : increased inflation decreases the real impact of injections. exchange rates affect trade and demand.

Question 59

measuring the multiplier :

Answer 59

it’s difficult to measure precisely due to many changing factors. it’s influenced by MPC, MPS, MPT, MPM. it’s likely that those on low incomes will have a higher MPC, so AD will shift right if the government prioritises these.

Question 60

targeting the multiplier :

Answer 60

low income groups : low income means higher MPC. government spending : directing spending to low income groups leads to larger increases in AD and national income.

Question 61

challenges and limitations of the multiplier :

Answer 61

uncertainty : governments can’t predict the exact size of the multiplier in advance due to changing economic conditions. time lags : there’s a delay between the increase in income and it’s full effect on the economy.

Question 62

effects of changes in AD (multiplier) :

Answer 62

the multiplier increases AD more than the original injection, yet it needs sufficient spare capacity in the economy for it to raise output, not just prices.

Question 63

AS curve elasticity (multiplier) :

Answer 63

perfectly inelastic AS (classical LRAS) : the multiplier only raises prices in the long run, not output. elastic AS : the more elastic the curve, the larger the effect on output, and the smaller the effect on prices.

Question 64

short run vs long run (multiplier) :

Answer 64

the impact of the multiplier depends on whether the economy is in the LR or SR. in the LR, the effect on output is limited if AS is inelastic.

Question 65

optimal conditions for the multiplier :

Answer 65

higher MPC and low MPW and plenty of spare capacity cause larger effects on output. low spare capacity causes higher prices but little effect on output. at Y the economy is below FE. the government looks to increase spending to increase employment, moving equilibrium to Y1. however, the multiplier effect means that AD will increase beyond the initial injection by the government. this shifts demand from AD1 to AD2. a new equilibrium is at Y2. at FE, the policy will be counterproductive and only cause inflationary pressure.

Question 66

3 methods of measuring economic growth using GDP :

Answer 66

1. Income : adding up all factor incomes earned in a year (e.g. profits, salaries) 2. Output : looking at the final value of all goods/services produced in an economy in a year. 3. Expenditure : consumer expenditure, adding up all the expenditure on a country’s goods/services within a year.

Question 67

Higher unemployment - multiplier

Answer 67

When there is higher unemployment, firms can more easily expand their production to meet increased demand because there are more available workers. When demand rises, firms can hire additional workers without worrying about labor shortages. These workers earn income and spend it, which stimulates additional demand.