2.4 National Income

What is the circular flow of income?

The circular flow of income is an economic model that illustrates money flows in an economy

Define national income.

National income is the value of the output or the expenditure in an economy over a period of time

True or False?

In the circular flow of income, households supply the factors of production to firms

True.

In the circular flow of income, households supply the factors of production to firms

What do households receive in exchange for factors of production?

Households receive income as a reward for supplying factors of production

How do firms use the factors of production?

Firms use factors of production to produce goods and services

What is the relationship between expenditure and income in the circular flow?

Expenditure is equal to income in the circular flow of income

Define wealth.

Wealth is a stock of assets that can be used to generate income

What is the difference between income and wealth?

Income is measured through a flow of money in the economy. Wealth is measured through a stock of assets at one point in time in the economy

How do households use their income in the circular flow of income?

Households use their income to purchase goods and services from firms

What do firms receive in exchange for selling their goods and services?

Firms receive sales revenue in exchange for goods and services

True or False?

National income can only be calculated using the income approach

False

National income can be calculated using both the income approach and expenditure approach

What are the four factors of production?

The four factors of production are land, labour, capital and enterprise

What are injections in the circular flow of income?

Injections are the additions of money into the circular flow of income that increase national income

What are withdrawals in the circular flow of income?

Withdrawals are the leakages of money from the circular flow of income that reduce national income

List the three types of injections

• increased government spending

• increased investment

• increased exports

List the three types of withdrawals

• increased savings by households

• increased taxation by the government

• increased import purchases

What happens when injections are greater than withdrawals?

When injections are greater than withdrawals, net positive injections increase economic growth

What happens when withdrawals are greater than injections?

When withdrawals are greater than injections, net negative withdrawals lead to a fall in economic growth

How does an increase in interest rates affect the circular flow of income?

An increase in interest rates increases savings (a withdrawal) and reduces consumption and investment (an injection). This reduces the circular flow of income

True or False?

Injections always lead to economic growth

False.

Injections only lead to economic growth if they are greater than withdrawals

What is the positive multiplier effect?

The positive multiplier effect is when the economy grows by a greater amount than the size of the initial injection. For example, an increase in investment will stimulate further rounds of spending

How does government spending affect the circular flow of income?

Increased government spending is an injection that can lead to a rise in the circular flow of income

What impact does increased spending on imports have on the circular flow of the income?

Increased spending on imports is a withdrawal that can lead to a fall in the circular flow of income

Which factors influence the size of the multiplier?

• the marginal propensity to consume (MPC)

• the marginal propensity to save (MPS)

• the marginal propensity to import (MPM)

• the marginal propensity to tax (MPT)

What is real national output equilibrium?

Real national output equilibrium occurs when the aggregate demand curve intersects with the aggregate supply curve. It is where AD is equal to AS

How do classical economists view the long-run equilibrium of real national output?

Classical economists believe the economy will always return to its full potential level of real national output in the long-run. All resources will be fully and efficiently employed

How do Keynesian economists view the long-run equilibrium of real national output?

Keynesian economists believe that the economy can still operate below full employment even in the long-run

What does the LRAS curve represent in the classical model?

In the classical model the LRAS curve represents the maximum possible output of an economy using all of its scarce resources fully and efficiently

True or False?

In the classical model, real national output equilibrium always occurs at full employment

True

In the Classical model real national output equilibrium always occurs at full employment.

How does the Keynesian LRAS curve differ from the classical LRAS curve?

The Keynesian LRAS curve is price elastic at lower price levels whereas the Classical LRAS curve is vertical. It is always perfectly price inelastic at all price levels

What causes the AD curve to shift?

• Consumption (C)

• Investment (I)

• Government spending (G)

• Net trade (X-M)

What causes the SRAS curve to shift?

• Costs of production

• Changes in exchange rates

• Changes in tax rates

How does an increase in AD affect the price level and the equilibrium of real national output in the classical model?

An increase in AD in the classical model leads to higher price levels and real national output in the short-run

How does an increase in the LRAS affect the price level and the equilibrium of real national output in the classical model?

An increase in the LRAS in the Classical model leads to lower price levels and higher real national output

What is a negative output gap?

A negative output gap is when the equilibrium of real national output is below the full employment level of real national output

How does the Keynesian model explain price stickiness?

The Keynesian model explains price stickiness as an inability to adjust prices and wage rates quickly to a change in macro-economic conditions

What is the multiplier ratio?

The multiplier ratio is the size of the change in real income in relation to the size of the injection that created the change

How does the multiplier process work?

The multiplier process works through generating further rounds of spending. One person's spending becomes another person's income

What factors affect the size of the multiplier?

size of the multiplier is affected by the size of the withdrawals from the circular flow of income:

• Savings (S)

• Taxes (T)

• Imports (M)

Define the term marginal propensity to consume (MPC)

Marginal propensity to consume is the proportion of additional income that is spent

Define the term marginal propensity to save (MPS)

Marginal propensity to save is the proportion of additional income that is saved

Define the term marginal propensity to tax (MPT)

Marginal propensity to tax is the proportion of additional income that is paid in tax

Define the term marginal propensity to import (MPM

Marginal propensity to import is the proportion of additional income that is spent on imports

State the formula for the multiplier in terms of the MPC

$$\frac{1}{1-\left(MPC\right)}$$

State the formula for the multiplier in terms of the withdrawals

$$\frac{1}{\left(MPS+MPM+MPT\right)}$$

How does an increase in tax rates affect the multiplier?

An increase in tax rates reduces the value of the multiplier

How does an increase in interest rates affect the multiplier?

An increase in interest rates reduces the value of the multiplier. It increases the incentive to save and decreases consumption as borrowing is more expensive

True or False?

The multiplier effect occurs instantaneously

False.

The multiplier effect takes time as further rounds of spending work through the economy