10 circular flow

circular flow

• model illustrating how money, goods, and services move through an economy

• represents the interactions between households and businesses in the production and consumption of goods and services

injection

• additions to the circular flow

• income

• exports

• government spending

withdrawal (leadkage)

• factors that leas to income not being passed on within the circular flow

• savings

• tax

• imports

saving

the portion of income not spent on consumption and instead set aside for future use

investment

money spent on capital goods to generate future income flows

what causes businesses to invest

• low interest rates

• high confidence

• higher income

• lower corporation tax

• technology to replace obsolete assets

what causes households to save

• high interest rates

• threat of recession

• higher national income

• age of population

what causes households to save less

• low interest rates

• high consumer confidence

• economic growth

disposable income

Income available to households after taxes and necessary expenses are deducted, which can be used for saving or consumption

saving ratio

The proportion of disposable income that households save rather than spend on consumption

positive multiplier effect

• a situation where an increase in injections (such as investment, government spending, or exports) leads to a larger final increase in GDP

• an initial increase in spending creates income for someone, who then spends part of that income, which becomes income for someone else, and the cycle continues

negative multiplier effect

• a situation where a decrease in injections or an increase in leakages (like savings, taxes, or imports) leads to a larger fall in GDP

• a cut in spending reduces income, leading to less consumption and further declines in income/output throughout the economy

reasons for an higher multiplier

• Marginal propensity to consume (MPC) is high

  • When people receive extra income, they spend a large portion of it, fuelling further rounds of spending

• Low savings rate

  • Less income is saved, meaning more money continues to circulate in the economy.

• Strong consumer and business confidence

  • People are more likely to spend and invest, amplifying the impact of initial injections.

• Low taxes

  • More disposable income is available to be spent rather than taken out of the circular flow.

• Spare capacity in the economy

  • If there's unemployment or unused resources, increased demand leads to more output rather than just higher prices.

Reasons for the Negative Multiplier Effect

• High marginal propensity to save (MPS)

  • People save most of their income instead of spending it, weakening the cycle of income generation.

• High taxes

  • A larger portion of income is withdrawn by the government, reducing consumers' spending power.

• High import spending (high marginal propensity to import)

  • Increased income leads to more spending on foreign goods, so the money leaves the domestic economy.

• Falling confidence

  • If consumers and firms are pessimistic, they cut back on spending and investment, deepening downturns.

• Austerity measures

  • Cuts in government spending or tax hikes reduce demand and can trigger a downward spiral in output and employment.

additional income equation

MPC + MPS + MPM(import) + MPT(tax)

multiplier formula

1 / (1 - MPC)

importance of the MPC

• confidence

  • if consumers are confident they will consume more

• household income level

  • with lower incomes, households will spend a greater proportion of income on essential goods and services, increasing their MPC

• interest rate

  • higher interest rates makes borrowing more expensive and saving more attractive so the MPC falls

real income

the actual income of an individual or group, adjusted for inflation, reflecting the purchasing power of money

nominal income

the income of an individual or group without adjusting for inflation

marginal propensity to consumer

the fraction of additional income that a household consumes rather than saves, influencing overall spending in the economy

marginal propensity to save

the fraction of additional income that a household saves rather than consumes, impacting savings rates and investment in the economy

marginal propensity to tax

the fraction of additional income that a household pays in taxes rather than consumes or saves, influencing government revenue and economic behaviour

marginal propensity to import

the fraction of additional income that a household spends on imported goods rather than domestic products, worsening the current account balance and affecting domestic production

marginal propensity to withdraw

the fraction of additional income that is not spent in the domestic economy, affecting overall demand and economic growth

aggregate demand

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

AD =

C + I + G + (X - M)

why does the AD curve slope downwards

• income effect

  • as price level falls the real value of income rises, money goes further

• substitution effect

  • as the price level falls, UK products become cheaper to international buyers and so the demand for UK goods and services rises

• interest rate effect

  • low inflation results in lower interest rates, which encourage borrowing and spending, increasing aggregate demand

what causes AD to shift

• change in any C + I + G + (X - M)

consumption

• consumer expenditure on goods and services, included durable and non durable goods

• goods - visibles

• services - invisibles

• credit - money flowing in

• debt - money flowing out

factors effecting investment

• business confidence

• interest rates

• depreciation

• technological advancements

• income

• substitutes

• profit retained

• price of capital

factors affecting consumption

• taxation

• interest rates

• confidence

• wealth

• distribution of income

• MPC

• wealth effect - when prices of assets fall, consumers feel poorer and reduce spending

• age, size of population

government spending

expenditure by the government to influence economic activity, including public services, infrastructure or welfare payments

factors effecting government spending

• economic growth

• unemployment rates

• inflation rates

• tax income

• shocks

• state of economy

accelerator effect

• a rise in national income results in a proportionately larger rise in investment

• businesses invest lots now so then they can produce extra units when demand increases, leading to higher production and investment

capital output ration

• ratio of capital required to produce a given level of output, indicating how efficiently capital is used in the production process

• invest 400, get an every 100 every year after the investment = capital out ration 4:1

multiplier and accelerator together

• increase in spending

• multiplier effect

• rise in national income

• accelerator effect

• increase in investment

• back to top

net exports

• X - M, trade balance

• when exports are positive there is a trade surplus

• when exports are negative there is a trade deficit which reduces AD

factors effecting net exports

• strength of pound

• if UK goods are competitive

• tariffs

• substitutes

• inflation

• consumer income

• non-price factors

  • reputation

  • quality

demand shocks

• when AD fall unexpectedly

• examples

  • credit crunch 2008

  • price bubbles

  • recession

aggregate supply

total quantity of output that producers in the economy are willing and able to supply at a given price level over a time period

factors affecting total production

• price level rises there is a profit incentive to supply more

  • as output increases production costs increase as resources become more scarce so firms raise prices to maintain profit margins

• price of raw materials

• cost of labour

• level of tax

• better production techniques

• improve quality / quantity of capital

• increased productivity

• availability of FOP

SRAS

Short-Run Aggregate Supply, representing the total production output available in the economy at varying price levels over a short time period

factors affecting SRAS

• if costs change at each price level/output

• average costs = total costs / output

• wage rates

• raw material and component prices

• taxation/subsidy

• interest rates affecting cost of loans

LRAS

• Long-Run Aggregate Supply, representing the total output of an economy when all input prices can adjust, indicating full employment and production capacity

• reflects an economies productive capacity

• the maximum output that can be produced with UK FOP

factors affecting LRAS

• only way to move LRAS is through an increase in the quality or quantity of FOP

• land

• labour

  • education, birth rate

• capital

  • technological advancements

• enterprise

  • training, tax incentives

Keynesian AS

1. AS is highly price elastic as producers have spare capacity and can increase output without higher costs

2. output can only be increased at the expense of an increase in PL as resources become more scarce and firms get close to full capacity

3. full employment, no extra resources available so AS becomes inelastic. FOP very expensive

supply side shocks

• rise in oil/gas prices

• strikes

• natural disaster

• breakthrough in technology

• change in ER

classical AD, AS diagram

1. AD increases above capacity

2. firms want to increase out put as there is a profit incentive (excess demand)

3. firms can only do this by working employees overtime

4. firms only willing to extend supply if PL increases to compensate

5. contraction down AD2

6. however in the long run costs increase at every price level

7. SRAS shifts left, resulting in a new equilibrium at a higher price level