intro to circular flow:
- households receive incomes and buy goods and services
- business hire factors of production
- government collect taxes and use it for government spending
- uk buys imports from other countries, and consumers buy uk exports
what do households do in the circular flow of income?
- save money (leakage), but with financial sector, money can be used for business investment to firms
- purchase goods and services, flow to firms(consumer spending)
- pay taxes to government (leakage)
- provide factors of production
what do governments do in the circular flow of income?
- social transfers to households ( G spending)
- govt purchases from firms
- receive taxes and reinvest
what do firms do in the circular flow of income?
- pay incomes to households
- pay taxes to government
- control market demand and supply
different measures of income
o Original income = Income from jobs, private pensions & interest from savings. o Gross income = original income + cash (welfare) benefits.
o Disposable income = gross income - direct taxes.
o Post-tax income = disposable income - indirect taxes.
gini coefficient as a measure of income inequality
commonly used measure, value between 0 and 1, higher the number, greater the inequality
other measures of income inequality
• Palma Ratio: Ratio of the income of richest ten percent of households to the income of the poorest forty percent
of households.
• S80/S20 ratio – this is the ratio of the total income received by the richest and poorest 20% of people.
• P90/P10 ratio – this is calculated as the ratio of incomes of the person at the 90th percentile and the person at
the 10th percentile.
what are the 3 injections within an open economy?
o Investment spending on new capital goods (I)
o Exports of goods and services (X)
o Government spending on public services (G)
what are the 3 leakages within an open economy?
o Savings (S) o Imports of goods and services (M) o Taxation (T)
changes in net injections and leakages
when inj=with, ie. I+G+X = S+M+T = equilibrium national income
if IGX higher national income will rise
When drawing extended AD/AS diagrams make sure that you
- Label the axes accurately as Price Level (y-axis) and Real GDP (x-axis)
- Label the AD and AS curves
- Indicate the macroeconomic equilibrium price level (P) and level of real GDP (Y)
- Carefully label any shifts in AD/AS and their associated new equilibrium points (this is really important!)
Short run equilibrium
• Equilibrium is established when AD intersects with AS (i.e. planned output and demand are in balance).
• What matters is whether total planned demand for goods and services (AD) is close to actual production from
domestic and external sources.
Impact of an Increase in Aggregate Demand
- An increase in AD causes an expansion of aggregate supply and a higher equilibrium level of national output.
- An outward shift of aggregate demand will bring about a cyclical rise in output and employment.
Impact of a Fall in Aggregate Demand
A decrease (inward shift) in AD causes a contraction of AS and a lower equilibrium level of national output.
Impact of an increase in Aggregate Supply
• An increase in AS causes an expansion of AD and a higher equilibrium level of national output.
• An outward shift of aggregate supply e.g. caused by lower unit costs should help to increase business profits.
- a,so decreases the general price level
Impact of a fall in Aggregate Supply
- A decrease in AS causes a contraction of AD and a lower equilibrium level of national output.
- An inward shift of aggregate supply e.g. caused by a rise in unit costs will lead to lower business profits.
Causes of Fall (Inward shift) in AS
- Brain drain – an outward migration of skilled workers
- Production shut-downs due to a pandemic / health crisis
- Higher costs from higher global commodity prices
- Effects of natural disaster / political conflict / civil war
Possible Macro Consequences of inward shift of AS
- May cause higher inflation if potential supply falls
- may reduce real gdp growth
- may lead to lower profits, investment and employment
- may worsen the trade balance if export sectors are hit
Formula for multiplier (closed economy with no government)
Multiplier = 1 / (marginal propensity to save) Multiplier = 1 / (1-marginal propensity to consume)
eg, if MPC = 0.9, and gov increases spending by 50000 multiplier = 1/0.1 = 10
10 x 50000 = £500000 added to circular income
Formula for multiplier (a closed economy with a government sector)
o The calculation for the value of the multiplier is:
o Multiplier = 1 / (sum of the marginal propensity to save + marginal rate of tax)
Formula for multiplier (an open economy with a government sector)
o An open economy engages in international trade of goods and services with other countries o The calculation for the value of the multiplier is:
Multiplier = 1 / (sum of the propensities to save + tax + import)
Positive multiplier effect:
When an initial increase in an injection (or a decrease in a leakage) leads to a greater final increase in
real GDP.
Negative multiplier effect:
When an initial decrease in an injection (or an increase in a leakage) leads to a greater final decrease in real GDP.
MPC =
change in consumption following a change in income
i.e. change in total consumption / change in gross income
depends on factors that affect consumption
