ECONOMICS - Theme 2

What is the Circular Flow of Income

flow of goods and service between households and firms and their corresponding payments in money terms

What goes to Firms in circular flow of payments

Land/Labour/Capital from households( output) and PAYMENTS for goods and services(income)

What goes to Households in the circular flow of payments

Income( wages, rent and profits), Output (goods and services)

Injections into the circular flow of income

• Investment ( by firms)

• Exports

• Government Spending

Withdrawals from the circular flow of income

• Taxes

• Savings

• Imports

BATHTUB ANALOGY- what happens if the water rises

GDP Increases - economic growth

What happens if bathtub increases

Factors of production increase - increase quality or quantity of land labour or capital

What does size of bathtub represent

Economic capacity

What happens is level of water really low

Resources not used efficiently, there is unemployment and the economy is functioning at low capacity

What happens if the bathtub overflows

Too much GDP/Demand in the economy so inflation occurs

not enough capacity to meet the new demand

What is income

The amount of money received on a regular basis

What is wealth

An accumulation of assets

What is GDP

the total value of all goods and services produced in an economy

What is the income method ( National Income)

the sum of all incomes received by the factors of production ( rent, wages and profits)

What is the output method

the combined value of the final output ( goods and services) produced. Excludes intermediary goods

The Expenditure Method

the sum of all the spending in an economy on goods and services. Known as aggregate demand

Who spends in the Expenditure Method

HOUSEHOLDS ( 65%)

BUSINESSES

GOVERNMENT

(IMPORTS-EXPORTS)

Aggregate Demand

the total demand for goods and services in an economy at a given price level

Formula for AD

C + I ( spending by firms on capital expenditure) + G + (X-M)

Consumption Evaluation point

65% of AD - has a larger impact than changes to G I OR X-M

What is consumption

spending by households on NEW goods and services, with the exception of purchases of new housing

Factors influencing consumption

• Wealth effect

• Inflation

• Availability of Credit

• Population

• Income tax

• Interest Rates

• Expectations and Consumer Confidence

• Expectations of future pries

Wealth Effect

Eg House valuations or valuations of their assets increase people feel more financially secure and have higher CONSUMER CONFIDENCE even though they have no increase in income so they spend more

What is used to measure the wealth effect

GFK Index- quantifies consumer confidence levels

How do equity release schemes increase C

people have more consumer confidence, they remortage their house so they have more cash, increase C

Income Tax cuts

increase in disposable income due to decrease in tax ( VAT ETC) so increase C BUT DEPENDS UPON MPC

Increased availability of credit

Credit Crunch of 08- due to lack of lending available as banks lacked confidence so a recession occured

Short run - more borrowing so increased spending so increased consumption

Long run - people cant pay back the money that they owe so their spending and consumption will be reduced because it needs repaying WITH INTEREST

Short run - more borrowing so increased spending so increased consumption

Long run - people cant pay back the money that they owe so their spending and consumption will be reduced because it needs repaying WITH INTEREST

Population Increase

increase in population ( increased immigration or birthrates) leads to increased households so increased consumption

Interest Rates decrease

Cost of borrowing decrease, so increase C
Mortgage payments decrease so Increase disposable income so Increase C
Earn less interest on your savings so less saved more spent

DEPENDS ON SIZE OF INTEREST RATE
DEPENDS ON WHETHER CREDIT CRUNCH OR NOT
Mortgage depends on size of capital loan ( actually paying back what was borrowed)

Mortgage payments decrease so Increase disposable income so Increase C

Earn less interest on your savings so less saved more spent

DEPENDS ON SIZE OF INTEREST RATE

DEPENDS ON WHETHER CREDIT CRUNCH OR NOT

Mortgage depends on size of capital loan ( actually paying back what was borrowed)

Expectations and Consumer Confidence

If consumers are more optimistic and have more job security then they will spend more and increase C

IF MADE REDUNDANT THEN THEY HAVE REDUNDANCY PAYMENTS so consumption wont rapidly decrease until these stop.

IF MADE REDUNDANT THEN THEY HAVE REDUNDANCY PAYMENTS so consumption wont rapidly decrease until these stop.

Inflation

Increased inflation then decreased real incomes so weaker consumption.

IN 2010 Teacher real pay minused by 13%

IN 2010 Teacher real pay minused by 13%

Expectations of future price changes

if people think that inflation will occur in the future they will spend more now and increase C,

If they think deflation will occur they may prolong their wait to spend

Depends upon their real income though

If they think deflation will occur they may prolong their wait to spend

Depends upon their real income though

Marginal Propensity to Consume (MPC)

How much of an increase in consumer spending there would be for an extra unit of income ( eg how much of an extra pound consumes would spend)

Why is high MPC good?

for each pound more is spent so c increases

Lower income, decrease in tax is regressive so more proportion of their income so they will spend more so C increases

Higher Income, decrease in tax less likely to have a greater impact on MPC, but firms more likely to stay in the UK ( laffer - LATVIA CHEAP), and create new businesses and jobs

Lower income, decrease in tax is regressive so more proportion of their income so they will spend more so C increases

Higher Income, decrease in tax less likely to have a greater impact on MPC, but firms more likely to stay in the UK ( laffer - LATVIA CHEAP), and create new businesses and jobs

What is MPM

Marginal Propensity to Import

Why is a high MPM bad

how much of an additional unit of income consumers spend on imports - more imports more withdrawals from the economy, so will not increase AD by much

To tackle use TARIFFS on imports so more expensive and people use domestic products and increase C

To tackle use TARIFFS on imports so more expensive and people use domestic products and increase C

ANIMAL SPIRITS

A factor that influences C or I which emphasises the role of emotion and instincts which guide and influence human behaviour, even when economic data states otherwise

What does the data show about animal spirits' influence

Although peoples own financial situations and the general state of the economy nearly reached their prior state after the 08 Crash, the likelihood of consumers likely to make a major purchase hasn't recovered due to the lack of confidence by firms and consumers

The paradox of thrift ( tinkerbell effect)

If people fear a recession then they will spend less and save more, due to this fear it actually brings about the very recession that they feared as it reduces AD

How does Animal Spirits affect Govt and AD

the irrational nature means that although policy makers and government may intervene to try and increase employment and consumption but if consumer confidence is low then any effects will be limited.

Investment

spending by businesses in an economy

What does Investment include

Capital expenditure - influences productive capacity
Includes machinery, factories ,buildings and equipment etc

Investment increases the productive capacity ( shifts PPF curve outwards)

Includes machinery, factories ,buildings and equipment etc

Investment increases the productive capacity ( shifts PPF curve outwards)

What type of spending is NOT included in AD and what percentage of AD does investment represent

Intermediate goods ( avoids double counting) 15-20%

15-20%

Net Investment

Gross investment minus depreciation ( wear and tear)

Gross Investment

total investment expenditure in a given time period

How interest rates affect investment

High Interest rates on bonds and bank loans make it more expensive to borrow so less likely to invest as it is less profitable

Can miss out on high returns on savings so less likely to invest - higher opportunity cost to get high returns on your savings if you invest

Higher returns on savings means less demand so less profitable to invest

Changing interest rates threaten capital expenditure as most of these are financed through borrowing

Even thinking interest rates will change will affect investment

Can miss out on high returns on savings so less likely to invest - higher opportunity cost to get high returns on your savings if you invest

Higher returns on savings means less demand so less profitable to invest

Changing interest rates threaten capital expenditure as most of these are financed through borrowing

Even thinking interest rates will change will affect investment

EVALUATION FOR INTEREST RATES ON INVESTMENT

Depends on size of change of interest rates

Depends on how long the investment project is- if it spans several years then a short term rise in interest rates will not deter any spending

Depends on how long the investment project is- if it spans several years then a short term rise in interest rates will not deter any spending

OTHER INFLUENCES ON INVESTMENT

InflationInflation
Animal Spirits
Government Intervention
Availability of Credit
Business and Consumer Confidence
Consumption
Expectations of future price changes
Demand for exports