AS Macroeconomics Notes
The circular flow of income model
Firms, households and the government interact and exchange resources.
- Households supply factors of production in exchange for a wage.
- Firms supply goods and services to households in exchange for
money.
- Governments spend on state goods and services such as social
welfare, education and grants, they receive this money from taxes
paid by households and businesses.
In this model, income = output = expenditure.
Injections (money entering Withdrawals (money leaving
economy) economy)
Investment Saving income
Government spending Tax
Revenue from exports Money spent on imports
A state of equilibrium is reached when the rate of withdrawals = the rate
of injections
Net injections = expansion of national output
Net withdrawals = contraction of production and therefore output
The multiplier process
This occurs when an initial increase in AD leads to an even bigger increase
in national income. An injection of income into the circular flow causes
economic growth as more jobs are created, higher incomes, more
spending and resulting in more income. i.e. one person’s spending is
another person’s income.
It is also possible to have a ‘reverse’ multiplier. This means that a
withdrawal of income from the circular flow could lead to an even larger
decrease in national income, decreasing economic growth.
,If an economy has a lot of spare capacity, extra output can be produced
quickly cheaper. This makes SRAS elastic and it means the size of the
multiplier will be larger. A small increase in AD will lead to a large increase
in national income.
If SRAS is inelastic, the multiplier effect is likely to be smaller than its
potential. This is because if AD increases, prices will increase more than
national income. This higher rate of inflation will lead to higher interest
rates, discouraging spending and borrowing and encourage saving.
The units of AD
AD is the total demand in the economy. It measures spending on goods
and services by consumers, firms, the government and overseas
consumers and firms. It is made up of the following components, which
make up the equation: C + I + G +(X-M).
Consumption:
This is how much consumers spend on goods and services. This is the
largest component of AD (60%) and is therefore most significant to
economic growth.
Disposable income: the amount of income consumers have left over after
taxes and social security charges have been removed. It is what
consumers can choose to spend. Consumer income might come from
wages, savings, pensions, benefits and investments, such as dividend
payments.
Influences on consumer spending:
- Interest rates : if interest rates are low, it is cheaper to borrow and
reduces the incentive to save, so spending and investment increase,
as well as lowering debt. This increases the disposable income of
households. However, there are time lags between the change in
interest rates and the rise in AD.
- Consumer confidence and expectations: if consumers have higher
confidence levels, they will invest/spend more, because they feel as
though they will get a higher return on them. This is affected by
anticipated income and inflation. If consumers fear unemployment
or higher taxes, consumers may feel less confident about the
economy, so they are likely to spend less and save more.
Investment:
¾ of this comes from private sector firms. The other ¼ is spent by the
government on, for example, new schools. This is the smallest component
of AD (15%).
, Influences on investment:
- Economic growth: If growth is high, firms will be making more
revenue due to higher rates of consumer spending. This means they
have more profits available to invest.
- Business expectations and confidence: if firms expect a high rate of
return, they will invest more, otherwise they will postpone
investment. Expectations about society and politics could affect
investment, for example, a change in government. Keynes coined
the term animal spirits when describing instinctual behaviour when
investing in an economy.
- Demand for exports: the higher demand is, the more likely it is that
firms will invest because they expect higher sales.
- Interest rates: investment increases as interest rates falls. The
higher interest rates are, the greater the opportunity cost of not
saving the money. High interest rates might make firms expect a fall
in consumption, which is likely to discourage investment.
- Access to credit: if banks are unwilling to lend, it is either more
expensive or not possible to gain the funds for investment, without
using retained profit. The availability of funds is dependent on the
level of saving in the economy.
- Taxation: The rate of corporation tax could affect investment. Lower
taxes means firms keep more profits, which could encourage
investment.
Government spending:
This is how much the government spends on state services, such as
schools and the NHS. Transfer payments are not included in this figure,
because no output is derived from them. The third largest component of
AD (20%)
Influences on government expenditure:
- The trade cycle : this refers to the periods of booms and busts.
Output increases in periods of economic growth and falls in
recessions causing negative growth. Governments might increase
spending to try and stimulate the economy. This will increase the
government deficit. During periods of growth, governments may
receive more tax revenue since consumers will be spending more
and earning more. They may decide to spend less, since the
economy does not need stimulating, and fewer people will be
claiming benefits.
- Fiscal policy: governments use fiscal policy to change government
spending and taxation. Governments might spend on public goods
and merit goods, as well as welfare payments. Fiscal policy is a
demand-side policy.
Current account/balance of payments:
The circular flow of income model
Firms, households and the government interact and exchange resources.
- Households supply factors of production in exchange for a wage.
- Firms supply goods and services to households in exchange for
money.
- Governments spend on state goods and services such as social
welfare, education and grants, they receive this money from taxes
paid by households and businesses.
In this model, income = output = expenditure.
Injections (money entering Withdrawals (money leaving
economy) economy)
Investment Saving income
Government spending Tax
Revenue from exports Money spent on imports
A state of equilibrium is reached when the rate of withdrawals = the rate
of injections
Net injections = expansion of national output
Net withdrawals = contraction of production and therefore output
The multiplier process
This occurs when an initial increase in AD leads to an even bigger increase
in national income. An injection of income into the circular flow causes
economic growth as more jobs are created, higher incomes, more
spending and resulting in more income. i.e. one person’s spending is
another person’s income.
It is also possible to have a ‘reverse’ multiplier. This means that a
withdrawal of income from the circular flow could lead to an even larger
decrease in national income, decreasing economic growth.
,If an economy has a lot of spare capacity, extra output can be produced
quickly cheaper. This makes SRAS elastic and it means the size of the
multiplier will be larger. A small increase in AD will lead to a large increase
in national income.
If SRAS is inelastic, the multiplier effect is likely to be smaller than its
potential. This is because if AD increases, prices will increase more than
national income. This higher rate of inflation will lead to higher interest
rates, discouraging spending and borrowing and encourage saving.
The units of AD
AD is the total demand in the economy. It measures spending on goods
and services by consumers, firms, the government and overseas
consumers and firms. It is made up of the following components, which
make up the equation: C + I + G +(X-M).
Consumption:
This is how much consumers spend on goods and services. This is the
largest component of AD (60%) and is therefore most significant to
economic growth.
Disposable income: the amount of income consumers have left over after
taxes and social security charges have been removed. It is what
consumers can choose to spend. Consumer income might come from
wages, savings, pensions, benefits and investments, such as dividend
payments.
Influences on consumer spending:
- Interest rates : if interest rates are low, it is cheaper to borrow and
reduces the incentive to save, so spending and investment increase,
as well as lowering debt. This increases the disposable income of
households. However, there are time lags between the change in
interest rates and the rise in AD.
- Consumer confidence and expectations: if consumers have higher
confidence levels, they will invest/spend more, because they feel as
though they will get a higher return on them. This is affected by
anticipated income and inflation. If consumers fear unemployment
or higher taxes, consumers may feel less confident about the
economy, so they are likely to spend less and save more.
Investment:
¾ of this comes from private sector firms. The other ¼ is spent by the
government on, for example, new schools. This is the smallest component
of AD (15%).
, Influences on investment:
- Economic growth: If growth is high, firms will be making more
revenue due to higher rates of consumer spending. This means they
have more profits available to invest.
- Business expectations and confidence: if firms expect a high rate of
return, they will invest more, otherwise they will postpone
investment. Expectations about society and politics could affect
investment, for example, a change in government. Keynes coined
the term animal spirits when describing instinctual behaviour when
investing in an economy.
- Demand for exports: the higher demand is, the more likely it is that
firms will invest because they expect higher sales.
- Interest rates: investment increases as interest rates falls. The
higher interest rates are, the greater the opportunity cost of not
saving the money. High interest rates might make firms expect a fall
in consumption, which is likely to discourage investment.
- Access to credit: if banks are unwilling to lend, it is either more
expensive or not possible to gain the funds for investment, without
using retained profit. The availability of funds is dependent on the
level of saving in the economy.
- Taxation: The rate of corporation tax could affect investment. Lower
taxes means firms keep more profits, which could encourage
investment.
Government spending:
This is how much the government spends on state services, such as
schools and the NHS. Transfer payments are not included in this figure,
because no output is derived from them. The third largest component of
AD (20%)
Influences on government expenditure:
- The trade cycle : this refers to the periods of booms and busts.
Output increases in periods of economic growth and falls in
recessions causing negative growth. Governments might increase
spending to try and stimulate the economy. This will increase the
government deficit. During periods of growth, governments may
receive more tax revenue since consumers will be spending more
and earning more. They may decide to spend less, since the
economy does not need stimulating, and fewer people will be
claiming benefits.
- Fiscal policy: governments use fiscal policy to change government
spending and taxation. Governments might spend on public goods
and merit goods, as well as welfare payments. Fiscal policy is a
demand-side policy.
Current account/balance of payments:
