2.4 national income and 2.5 economic growth

Circular flow of income

an economic model that illustrates how money flows in an economy

Diagram analysis of the circular flow

• Households own the wealth in the economy

  • These are the factors of production

• Households supply their factors of production to firms and receive income as a reward

  • They receive rent for land, wages for labour, interest for capital, and profit for enterprise

  • With this income, they purchase goods/services from firms

• Firms purchase factors of production from households

• They use these resources to produce goods/services

• They sell the goods/services to households and receive sales revenue

• National income is the value of the output of an economy over a period of time

  • It can be calculated using the income approach or expenditure approach

  • Expenditure = income

• Income is a flow in the economy, whereas wealth is a stock of assets that can be used to generate income

Injections

add money into the circular flow of income and increase its size

• Increased government spending (G)

• Increased investment (I)

• Increased exports (X)

withdrawals

remove money from the circular flow of income and reduce its size

• Increased savings by households (S)

• Increased taxation by the government (T)

• Increased import purchases (M)

Injections > withdrawals

economic growth

• vise versus is a fall in real GDP

the multiplier effect

Occurs when an injection into the circular flow causes the real national income to increase by a greater amount

• size of the multiplier is dependent on the (MPC), (MPS), the marginal propensity to import (MPM) and the marginal propensity to be taxed (MPT). If the marginal propensity to withdraw is smaller, then the multiplier will be higher, and vice versa

multiplier ratio

the ratio of change in real income to the injection that created the change

Marginal propensity to consume

The proportion of additional income that is spent

marginal propensity to save

The proportion of additional income that is saved 

marginal propensity to tax

The proportion of additional income that is paid in tax 

marginal propensity to import

The proportion of additional income that is spent on imports

calculating the MPC

calculating withdrawals

Significance of the Multiplier in Shifting AD

• if taxes increase, the value of the multiplier reduces

• If interest rates increase, savings increase and consumption decreases, and the multiplier reduces

• If exchange rates appreciate, the level of imports will increase and the multiplier decreases

• If confidence in the economy increases consumption increases and the multiplier increases

short run economic growth

Changes to any of the components of aggregate demand (AD)

• An increase in real GDP = economic growth

Long run economic growth

Caused by improvements to the quality or quantity of the factors of production

Actual growth

the increase in the productive potential of an economy as demonstrated by a shift outward of the production possibilities frontier (PPF) or the long-run aggregate supply (LRAS) curve

potential growth

when there is an increase in the real value of goods and services produced in an economy over a given period of time

output gap

the difference between the actual level of output (real GDP) and the maximum potential level of output

positive output gap

when real GDP is greater than the potential real GDP

negative output gap

when the real GDP is less than the potential real GDP

• there is spare capacity

Business cycle

refers to the changes in real GDP that occur in an economy over time

characteristics of a recession

• two consecutive quaters of negative growth

• high unemployment

• spare production capacity

• low confidence for firms/households

characterstics of a boom

• high economic growth

• decreasing unemployment

• demand pull inflation

Benefits of economic growth

• increased incomes

• decreased levels of poverty

• improvement in quality and quantity

• higher sales revenue

• higher gov tax revenue

costs of economic growth

• demand pull inflation

• lack of equity

• negative externalities

• increased inflation can harm export sale