What is the circular flow of income?

The circular flow of income shows the flow of money throughout the economy. A simple model of the circular flow of income is shown below.

What is the distinction between income and wealth?

Income is the flow of money that economic agents receive and includes wages, rent, interest and profit. Whereas wealth is the market value of the stock of assets that an economic agent owns at a particular point in time.

What are the impacts of injections into and withdrawals from the circular flow of income?

Injections into the circular flow of income increase the amount of money in the circular flow of income. Injections into the circular flow include:

1. Government spending (G).
2. Investment (I).
3. Exports (X).

Withdrawals from the circular flow of income decrease the amount of money in the circular flow of income. Withdrawals from the circular flow include:

1. Taxes (T).
2. Saving (S).
3. Imports (M).

When total injections into the circular flow of income exceed total withdrawals from the circular flow of income, there is a net injection into the circular flow of income, indicating that economic growth is taking place.

When total withdrawals from the circular flow of income exceed total injections into the circular flow of income, there is a net withdrawal from the circular flow of income, indicating a contraction in economic activity.

What is the real national output equilibrium?

The real national output equilibrium occurs when AS=AD.

The diagram below shows the economy at short-run equilibrium.

The short-run equilibrium position on the diagram above is at price level P and the real output level of Y where SRAS = AD.

The Classical long-run equilibrium is shown in the diagram below.

The Classical LRAS is perfectly inelastic. In the diagram above, the Classical long-run equilibrium is at the price level, P, and real output, Y where LRAS = AD.

The Keynesian long-run equilibrium is shown in the diagram below.

In the diagram above, the Keynesian long-run equilibrium is where LRAS = AD. In the example above, the long-run equilibrium is at the price level of P and the real output level of Y.

How can AS and AD diagrams be used to show how shifts of AD or AS cause changes in the equilibrium price level and real national output?

The diagram below shows the effect of an outward shift of the SRAS curve on the short-run equilibrium price level and real output.

As shown by the diagram, an outward shift of SRAS from SRAS to SRAS1 has led to a fall in the price level from P to P1 and an increase in real output from Y to Y1. The new equilibrium position is at the price level of P1 and the real output level of Y1.

The diagram below shows the effect of an outward shift of AD on the equilibrium price level and real output.

An outward shift of AD from AD to AD1 has resulted in an increase in the price level from P to P1 and an increase in real output from Y to Y1. The new equilibrium price level is at P1, and the new equilibrium real output is at Y1.

The diagram below shows the effect of an outward shift of AD on the Classical long-run equilibrium price level and real output. 

An outward shift in the AD curve from AD to AD1 will result in an equilibrium in the short run at price level P1 and real output level Y1. However, as the economy is operating at a level above full employment of resources, the price of resources will be bid up, leading to an inward shift of the SRAS from SRAS to SRAS1. This leads to the establishment of the equilibrium in the long run at price level P2 and real output level Y1.

The diagram below shows the effect of an outward shift of the Classical LRAS curve on the equilibrium price level and real output.

An outward shift of the Classical LRAS curve results in a fall in the price level from P to P1 and an increase in real output from Y to Y1. This leads to the establishment of the equilibrium in the long run at the price level P1 and real output Y1. 

The diagram below shows the effect of outward shifts of AD on the Keynesian long-run equilibrium price level and real output.

The effect on price level and real output depends on whether the economy is operating near full employment. For example, AD could be represented by the AD curve. The economy is operating at price level P and real output Y. An outward shift of AD along the perfectly elastic part of the Keynesian LRAS to AD1 will result in an increase in equilibrium real output to Y1, but no change in the equilibrium price level, which remains at P. At AD2, the LRAS curve is becoming less elastic as the economy is approaching full employment. At AD2, the economy is operating at an equilibrium price level of P2, and real output Y2. An outward shift of AD from AD2 to AD3 will result in an increase in the equilibrium price level to P3 and an increase in equilibrium real output to Y3. At AD4, the economy has reached full employment of resources and is operating at an equilibrium price level of P4, and equilibrium real output of Y4. An outward shift of AD from AD4 to AD5 will cause an increase in the equilibrium price level to P5, with no effect on the equilibrium real output which remains at Y4.

The diagram below shows the effect of an outward shift of the Keynesian LRAS curve on the equilibrium price level and real output.

If there is weak AD in the economy, then an outward shift of the Keynesian LRAS may have no effect on the equilibrium price level or real output. As shown above, with the AD curve, an outward shift of the Keynesian LRAS has had no effect on the equilibrium price level (P) or real output (Y) as AD is weak. However, at AD1, where there are large amounts of AD, an outward shift of the Keynesian LRAS curve from LRAS to LRAS1 has resulted in a fall in the equilibrium price level from P1 to P2 and an increase in real output from Y1 to Y2.

What is the multiplier ratio?

The multiplier ratio is the ratio of the change in real incomes to the change in injections into the economy that initially caused real incomes to change.

What is the multiplier process?

An initial injection into the economy (for example, the government spending more on public sector wages) is likely to directly increase the incomes of some individuals in the economy. These individuals are then likely to increase their consumption and spend more on goods and services, leading to an increase in AD. More spending on goods and services by some individuals leads to an increase in incomes for the producers that produce these goods and services, which these producers can then spend, for example, on more capital. This increases the incomes of other individuals in the economy due to a further increase in spending, and this cyclical effect carries on throughout the economy, leading to further increases in AD. This is the multiplier process. The multiplier process can also work in the other direction, whereby an increase in withdrawals from the economy may lead to further falls in incomes throughout the economy, this is known as the negative multiplier effect.

What are the effects of the multiplier on the economy? 

An initial injection into the economy is likely to be 'multiplied' out throughout the economy, leading to a large increase in incomes, this is the multiplier effect. Conversely, withdrawals from the circular flow of income are also likely to be 'multiplied' out throughout the economy, due to the multiplier effect, leading to a large fall in incomes in the economy.

What are the marginal propensities and their effects on the multiplier? 

The marginal propensity to consume (MPC). This is the proportion of additional income that economic agents spend on goods and services. A larger MPC will result in a larger multiplier as this will affect the total amount of consumption throughout the economy after an initial injection.

The marginal propensity to save (MPS). This is the proportion of additional income that economic agents save. A larger MPS will result in a smaller multiplier, as if economic agents save a larger proportion of their additional income rather than spend it, this will reduce the total potential amount of consumption after an initial injection.

The marginal propensity to tax (MPT). This is the proportion of additional income that is taxed. A larger MPT will result in a smaller multiplier. This is because if a large proportion of the additional income of an economic agent is taxed, they will not be able to spend a large proportion of their additional income on goods and services.

The marginal propensity to import (MPM). This is the proportion of additional income that economic agents spend on imports. A larger MPM will result in a smaller multiplier. This is because if economic agents spend a large proportion of their additional income on imports, then this means that a smaller proportion of additional income is likely to be spent on domestic goods and services.

What is the formula for the multiplier?

Multiplier =  1/(1-MPC)=1/MPW

MPW = MPS + MPT + MPM

For example, if the value of MPC is 0.8, the multiplier can be calculated as 1/(1-0.8) = 1/0.2 = 5. Hence, with this example with a multiplier of 5, an increase in injections (for example government spending) of £100,000 will lead to a £500,000 increase in national income as £100,000 x 5 = £500,000.

What is the significance of the multiplier for shifts in AD?

A net injection in the circular flow of income is likely to lead to an outward shift of the AD curve. The multiplier effect is then likely to lead to further outward shifts of the AD curve. A net withdrawal from the circular flow of income is likely to lead to an inward shift of the AD curve. The multiplier effect is then likely to cause further inward shifts of the AD curve.

What are some factors which could cause economic growth?

1. Level of innovation. High levels of innovation in the economy may lead to efficiency improvements, potentially resulting in more output being produced and economic growth taking place.
2. Level of investment. High levels of investment within the economy are likely to lead to rising output levels. For example, an increase in expenditure on infrastructure is likely to result in reductions in transportation costs, making it cheaper for firms to produce more output, resulting in more economic growth.
3. Changes in government policies. A government may employ expansionary fiscal policy in order to try and boost aggregate demand to boost economic growth.
4. Size of the working population. An increase in the size of the working population (for example due to high levels of immigration) results in a larger labour pool, meaning more goods and services can be produced, likely resulting in economic growth taking place.

What is the distinction between actual and potential growth?

Actual growth is defined as the observed percentage change in the GDP of an economy over time. Potential growth is the maximum possible rate of economic growth over time.

Why is international trade important for (export-led) economic growth?

International trade can help to increase economic growth in economies. This is because economies can expand if there are high levels of demand for their exports. A high demand for a country's exports helps to boost aggregate demand, likely resulting in an increase in economic growth. This is export-led growth, as an economy has experienced economic growth through there being high demand for its exports.

What is the distinction between actual growth rates and long-term trends in growth rates?

Actual growth rates show the observed percentage changes in the GDP of economies. Long-term trends in growth rates show the general trajectory of economic growth over extended periods of time.

What are positive and negative output gaps and why is it difficult to measure them?

Positive output gaps occur when the economic growth in an economy is above the economy's potential real output level. Negative output gaps occur when the economic growth in an economy is below the economy's potential real output level.

Positive and negative output gaps are often considered difficult to measure as it is often hard to discern where the potential economic real output level is and there are usually limitations in data availability, resulting in it being difficult to make accurate GDP estimates.

How can an output gap in an economy be illustrated on an AS/AD diagram?

The diagram below shows an AS/AD diagram with a Classical LRAS curve.

According to the Classical viewpoint, in the long run, the economy operates at full employment. In the diagram above, this is at AD = LRAS = SRAS, with the economy in equilibrium at price level P and real output level Y. No output gap exists. An increase in AD, for example in the diagram above to AD1, will result in an increase in the price level from P to P1 and an increase in real output to Y1. This real output level of Y1 is greater than the maximum potential real output level at Y where the economy is at full employment of resources. This results in a positive output gap between Y and Y1. 

If AD falls from AD to AD2 as shown in the diagram above, this leads to a fall in the price level from P to P2, and a fall in real output from Y to Y2. Y2 is below Y, demonstrating that the economy is not producing its maximum potential real output. As a result, a negative output gap exists between Y2 and Y.

A negative output gap can also be shown when using a Keynesian LRAS curve.

As shown above, when the economy is operating at full employment, real output is at Y. However, at AD1 where there is a price level of P1, the real output level is at Y1, which is below Y1. Hence a negative output gap exists between Y1 and Y.

What is the trade (business) cycle?

The trade (business) cycle monitors the fluctuations in economic activity over time. The trade cycle is characterised by periodic expansions and contractions in real output, unemployment and other macroeconomic indicators in the economy. There are 4 main stages:

1. Expansion.
2. Boom/peak.
3. Recession.
4. Slump/trough.

The diagram below shows the trade cycle.

What are the characteristics of a boom?

1. Economic growth is likely to be high. This is because economic output expands rapidly during a boom.
2. There is likely to be very low unemployment. This is because businesses are usually expanding during a boom, leading to more job opportunities and more derived demand for labour, likely leading to a fall in unemployment.
3. Rising incomes in the economy. This is due to falling unemployment and high levels of demand for goods and services during a boom, likely leading to more derived demand for labour and rising wages and hence leading to a rise in incomes.
4. High levels of inflation. High levels of AD during a boom may result in high levels of inflation.

What are the characteristics of a recession?

1. Economic growth is likely to be negative. Negative economic growth is likely to occur as during a recession an economy experiences a decline in economic growth for 2+ consecutive quarters.
2. Rising unemployment. As negative economic growth is taking place during a recession, there is likely to be rising unemployment as less output is being produced resulting in low demand for workers.
3. Falling incomes in the economy. Rising unemployment and falling derived demand for labour due to lower output during a recession are likely to result in falling incomes.
4. Deflation may occur. Due to weak levels of AD during a recession, there may be downward pressure on prices in the economy.

What are the impacts of economic growth on consumers?

Benefits:

1. Consumers' incomes are likely to rise during periods of economic growth. This is because, during periods of economic growth, there are large levels of demand for goods and services, leading to large amounts of derived demand for labour and likely increasing wages and hence incomes. This means that the consumer is likely to be able to spend as they may earn a higher income compared to before economic growth place.
2. Some consumers may benefit from the positive wealth effect. The positive wealth effect is likely to occur as asset prices often rise during periods of economic growth. The positive wealth effect means that consumers are likely to increase their expenditure as they feel richer.
3. Consumers may increase their spending as they feel more confident about the state of the economy during periods of high economic growth.

Costs:

1. Inflation, which is likely to occur during periods of economic growth, is likely to lead to a fall in purchasing power for consumers.
2. During periods of economic growth there may be rising income inequality as the proceeds of economic growth are unlikely to be shared equally amongst consumers.

What are the impacts of economic growth on firms?

Benefits:

1. Firms are likely to become more profitable during periods of high economic growth as firms may experience large increases in demand for their goods and services.
2. Firms may be more likely to invest during periods of economic growth as they are earning high levels of profit.
3. During periods of economic growth, there is also likely to be inflation. Inflation may mean that producers can be more flexible in the pricing of their goods and services.

Costs:

1. Firms may struggle with rising costs as, during periods of economic growth, factor input costs are likely to rise as firms demand lots of factor inputs to increase output.
2. During periods of economic growth firms may struggle to hire workers as there is likely to be less unemployment during periods of high economic growth.

What are the impacts of economic growth on the government?

Benefits:

1. The government is likely to spend less on unemployment-related benefits during periods of economic growth as there is likely to be a low level of unemployment when economic growth is taking place.
2. The government is likely to receive higher tax revenues during periods of economic growth. For example, firms are likely to be making higher profits, likely leading to a rise in corporation tax revenues for the government. Moreover, incomes are also likely to rise in the economy, so the government will likely benefit from an increase in income tax revenues.

Costs:

1. The government may face pressure to address potential problems that may arise from economic growth such as rising income inequality.
2. The government may have to spend more on infrastructure in order to improve the economy's infrastructure to cope with the rise in economic activity during periods of economic growth.

What are the impacts of economic growth on current and future living standards?

Benefits:

1. Technological advancements usually come about during periods of economic due to increased investment. Technological advancements help to improve current and future living standards.
2. Economic growth is likely to reduce absolute poverty. This is because, before economic growth took place, some workers may have been unemployed and earning no income at all. As a result of economic growth, these workers may be able to find employment and earn an income, reducing absolute poverty as these workers now have an income.

Costs:

1. Economic growth may lead to lifestyle changes. These lifestyle changes may lead to an increase in stress which is likely to reduce current and future living standards.
2. Economic growth may lead to more pollution which is likely to reduce current and future living standards as pollution may pose risks to public health.