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