2.2 how the economy works

Income vs wealth

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

What does the circular flow of income model show?

National income and the flow of money, resources and goods in an economy

What flows from households to firms in the circular flow of income in a closed economy?

Land, labour and capital & expenditure on goods and services

What flows from firms to households in a circular flow in a closed economy?

Rent, wages, interest and profit & goods and services

How can national income be calculated form the circular flow of income model?

Expenditure (Nominal GDP=Consumption + Govt. spending + Investment + Net exports [C+G+I+(X-M)])

Income (Wages + Rent + Interest + Profit [W+R+I+P])

Output (Total value of all finished goods/services produced within the economy each year)

Injections into Circular flow

G+X+I

Leakages from circular flow

M+T+S

Determinants of savings

Factors that influence an individual decision to save money rather than consume

Disposable vs discretionary income

Disposable- left after paying taxes

Discretionary- left after taxes and bills

Household savings ratio

Household savings as a proportion of household income

What is investment?

Expenditure by firms on capital goods

Equilibrium National Income

Where withdrawals are equal to injections and aggregate demand equals aggregate supply

Why is a large shadow economy a problem?

-unregulated

-no tax revenue

-GDP and growth won’t accurately reflect the economy

Problems with using GDP to measure economic growth

-Population

-inequality

-environmental issues

-shadow economy

Stages of economic cycle

Boom, slowdown, recession , recovery

Economic growth is an increase in?

Productive capacity of an economy

Actual growth

Increase in real GDP, total value of goods/services sold

National income

Monetary value of the flow of output of goods and services produced in an economy over a period of time

2 types of output gap

Positive and negative

Net exports

Difference between revenue gained from selling goods or services abroad and the expenditure on goods and services from abroad

Why is economic growth important?

-avoid negative output gap

-allows for improvements in living standards

-solving economic problem

-international competitiveness

-foster innovations

-environment protection regulations

-increase life expectancy

-decrease poverty

-infrastructure & public services

Problems of economic growth

-needs to be sustainable- avoid positive output gap- inflationary pressure

-income inequality

-unsustainable (environment, scarce resources)

-market failure- negative externalities

-happiness and wellbeing?

-unrecorded work

-ethical issues

Ethical issues

-ethical issues e.g over working, child labour

-urbanisation, swallows up good agricultural land

-increasing population

-countries suffer from low growth and may enter vicious cycle, low profit- low investment-low business confidence, lack of international competitiveness

Aggregate demand

Total demand for all goods and services in an economy at any given average price level

How is aggregate demand calculated

AD= C + G + I + (X-M)

Consumption

Total spending on goods and services by consumers in an economy

Investment

The total spending on capital goods by firmsGov

Government spending

Total spending by the govt. in the economy, including public sector salaries, public goods etc. (doesn’t include transfer payments)

What does an aggregate demand curve show

Relationship between average price level and total output (Real GDP) in an economy

Determinants of aggregate demand

Factors causing a shift of the AD curve

Consumption

• changes in consumer confidence

• changes in interest rates

• changes in wealth

• changes in level of disposable income

Exports

• changes in incomes from abroad

• changes in level of inflation

• changes in exchange rates

Imports

• changes in domestic income

• changes in level of inflation

• changes in exchange rates

Investment

• changes in business confidence

• changes in government intervention

• changes in interest rates

Government spending

• political decisions

• capital spending

• economic cycle

2/3 of AD in the UK (roughly) comes from what?

Consumption

Accelerator theory of investment

An increase in national income (GDP) results in a proportionately larger rise in capital investment spending

Positive ouput gap

When an economy’s actual level of output (GDP) is greater than its potential output (trend rate of GDP)

GDP

value of goods and services produced by factors within a country

An economy is experiencing growth in GDP below trend. In the short-run if aggregate demand is growing at a lower rate than productive capacity, what is the economy likely to experience

Negative output gap- low employment, low inflation

Why was CPI chosen as the means of measuring inflation?

It’s calculated using the same methods as those found in the EU

determinants of savings

• interest rates

• rising income enables higher savings

• economic growth

• the age of individuals

• cultural trends

• wealth

• inflation

determinants of consumption

• real disposable income

• interest rates

• employment rates

• availability of credit

• changes in household wealth e.g. property prices

• price expectations

• size and age structure of a country’s population

• consumer confidence

Aggregate demand

demand for a country’s goods + services over a period of time, at a given price level

Aggregate demand curve slopes downwards because at a higher price level…

-interest rates tend to be higher, therefore there’s less demand and businesses making expensive goods reduce output

-purchasing power is reduced so less is bought (and therefore businesses make less)

-foreign goods & services became relatively cheaper so less demand for UK output

3 methods of measuring GDP`

Output, expenditure, income

Supply shocks

a sudden, unexpected event that shifts an economy's Short-Run Aggregate Supply (SRAS) curve, leading to rapid changes in production costs, real output, and the general price level

Demand shock

a sudden, unexpected event that shifts the Aggregate Demand (AD) curve to the right or left, altering real output, employment, and the price level

Why is level of unemployment a reliable measurement of economic performance?

Because it provides a relative measure of how an economy is performing in relation to productive potential

Aggregate supply

Total supply of goods/services produced w/in an economy at a specific price level at a given time

Why is an SRAS curve upward sloping

Combined supply of all supply curves in an economy

As real output increases, firms have to spend more to increase production leading to higher average prices

Causes of shifts in (SR)AS

Change in cost of raw materials/energy

Change in wage rates

Change in tax rates

Long run aggregate supply

Potential capacity of an economy’s factors of production

Changes in factors that affect the quality/quantity of a factor of production will impact the LRAS of an economy, causing a shift

Classical economics LRAS shape

Straight vertical line

LRAS determinants

Technology

Productivity

Education & skills

Govt regulations

Demographics/migration

Competition policy

Institutional structure of economy

How do institutional factors affect the LRAS

Formal and informal institutions govern the behaviour of economic agents

They exert influence on LRAS

Can implement reforms that influence investment/entrepreneurship

Create policies promoting labour market flexibility, property rights, financial stability and infrastructure development etc.

Keynesian LRAS model

Looks like a backwards L

Supply elastic at low levels of output as there’s spare capacity so struggling firms will raise output w/o prices

Supply perfectly inelastic at a point of full employment (more price inflation as firms competing for scarce resources)

Why did Keynes believe in govt. spending

Economy may not always self-correct for full employment level of output for many years

Slowdown

Less output

Recessionary gap

Average prices eventually stop falling but output doesn’t

Economy doesn’t self-correct for years

Low confidence/high unemployment

Govt. should therefore increase expenditure & change negative sentiments about the economy

Things assumed to be constant in SRAS

• State of technology

•  Stock of natural resources

•  Level of capital

• Sticky prices- prices resistant to change

Multiplier effect

Any injection in the economy leads to a greater impact on the economy than the value of the injection

MPC formula

change in consumption/change in income

Accelerator process steps

-more demand for g/s

-increase in AD

-firms invest into capital goods

-further increase in AD

-increase in AD is multiplied

-larger growth in national income

-even more accelerated investment

Causes of shift in LRAS

•  Technological progress

•   Change in size/quality of labour force

•  Change in size & quality of capital stock through investment

•  Mobility of factors of production

•  Changes in factor productivity

•  Incentives to invest

•  Attitudes to work