4.2.2. How the macroeconomy works: the circular flow of income, aggregate demand/supply analysis and related concepts

• national income = total value of goods and services a country produces over a year

• GDP, GNI and NNP

Nominal NI/average price level

• these always equal each other

• NI = measured income received by different factors of production

• NO = measures actual goods and services produced by the economy

• NE= shows the spending of these incomes on the goods and services produced by the economy

If you are selling bread:

NI-wages received at each stage of production, adds together to the total value of the bread

NO- sale of bread added to NI

NE- price paid for finished product

Model that shows how money flows between the key components of the economy and

• money entering the circular flow of income

• Injections include investment, government spending and exports

• leakage of spending power out of the CFOI

• Withdrawals include savings,taxation and imports

National income is in equilibrium

Net withdrawal/leakage of demand out of the CFOI occurs causing NI to fall

Net injection of demand into the CFOI, National income rises

Measurement of the totals amount of demand for all finished goods and services produced in an economy

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

• C= Expenditure by households on UK produced goods and services

• I = Expenditure by firms on capital equipment

• G=Expenditure by government to include capital spending eg building hospitals and current spending e.g. teachers wages

• X=Expenditure by overseas consumers and firms on UK produced goods and services

• M= Expenditure by UK consumers and firms on overseas produced goods and services

curve has the familiar downward slope.

At a higher price level (P) the demand for real national income will be relatively low (Y) vice versa

Fall:

• Fall in exports

• Cut in GS

• Higher interest rates

• Decline in household wealth

Rise:

• Depreciation of the exchange rate

• Cuts in direct and indirect taxes

• Increase in house prices

• Expansion of supply of credit and lower interest rates

• combined spending of all households in an economy

• interest rates

• Wealth

• Level of income

• Expected future income

• Consumer confidence

• Availability of credit

• Distribution of income

• Expectation of future inflation

• The opposite of consumption is savings. If consumption decreases savings increase and vice versa.

• planned demand for capital goods in an economy

• Investment is a flow while capital is a stock. Investment needs to be measured over a period of time and not at a point in time.

Replacement:

• replacing old capital

• Maintains current size

Net:

• adds to the capital stock

• Increases productive potential

• Predictions on future sales

• Price of labour/capital

• Interest rates

• Predictions on future costs/profit

• Technical progress

• Gov policies

Actual personal saving/personal disposable income

The government can choose to spend money in the economy. This is called Fiscal spending.

This is known as Net Exports . Exports add to AD of an economy while Imports deduct from an economy.

• relative cost of the good

• Exchange rate

• Trade barriers

• Ability to produce a good

• an increase in any of the AD components

The government can choose to spend money in the economy. This is called Fiscal spending.

• how the economy is performing

• Budget

• Party in charge

• Expectations about the future

• amount of goods and services that businesses are prepared to produce assuming capital is fixed

• A rise in the general price level should stimulate an expansion of supply

• When prices are falling, production may contract

• A rise in the price level causes an expansion of aggregate supply

• A fall in the price level causes a contraction of aggregate supply

• Wages - if wage rates increase forms may substitute labour for capital

• Labour productivity (higher efficiency ceteris paribus lowers unit costs)

• Raw material and component prices such as glass, cement, rubber - if prices increase, firms cost of production increase and reduce SRAS

• Taxes and subsidies - an increase in business tax rates increases costs of production = SRAS decreases

• Increase in business subsidies lowers COP lowers SRAS

• Exchange rates and imports - many businesses import raw materials, if currency strengthens, this makes purchasing raw materials relatively cheaper and SRAS will increase

• Supply shock

• The amount of goods and services that can be produced in an economy assuming the level of capital is variable

• This is when all the available factors of production are employed and producing at their normal capacity level of output

The LRAS curve is vertical. An increase in the price level (e.g. to P1) won’t cause an increase in output because the economy is running at full capacity so it can’t create any more output.

Long run aggregate supply is determined by the factors of production — the LRAS curve will shift if there’s a change in the factors of production which affects the capacity of the economy.

2) An improvement in the factors of production increases the capacity of the economy

3) E.g. investment that leads to advances in technology and more efficient production will increase maximum output.

• rise in productive potential

• Gross = total investment on capital goods

• Net = gross investment adjusted for capital consumption

unexpected event that changes the supply of a product or commodity, resulting in a sudden change in its price.

• the higher the level of AD, the higher the level of EA

• A large part of government economic activity is designed to stimulate the various components of AD

• Any increase in the components will shift the AD curve to the right, and will increase the level of real national output

• occurs when an initial injection into the economy causes a larger final increase in the level of real national income/output

• concluded that the LRAS curve was upward sloping, and has a vertical section (like the classical LRAS curve), but at times an economy could settle at a level of output below full employment

Change in national income/ initial change in government spending

or

K = 🔼Y/ 🔼J

J = injections

• can happen in reverse due to a withdrawal from the economy

• Cuts in spending and increases in tax lead to a negative multiplier and a fall in GDP

• interest rates - if they’re high, consumption might not rise as much as consumers might save money

• Tax rates - withdrawal from the CFOI, if they’re high = less disposable income

• Imports - if disposable income increases, but is spent on imported goods, this counts as a withdrawal from the CFOI

• Spare capacity- any increase in AD may not be able to be met by firms, as a result the multiplier effect will be limited and inflation might occur

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

In other words, we often see a surge in capital spending by businesses when an economy is growing quite strongly.

• change in consumer spending following a change in investment

Percentage of disposable income