circular flow income and as/ad analysis

• What are the different measures of national income?

  • Gross Domestic Product (GDP): Total market value of final goods/services produced within a country.
  • Production Method: Value-added at each production stage.
  • Income Method: Sum of incomes earned (wages, rent, interest, profits).
  • Expenditure Method: Total expenditure on final goods (C + I + G + (X - M)).
• What are 3 more measures of national income?

  • Gross National Product (GNP): GDP + income from abroad - income earned by foreigners in the country.
  • Net National Product (NNP): GNP minus depreciation (capital wear and tear).
  • National Income (NI): Total income earned by factors of production (wages, profits, rents, interest).
• What is the difference between nominal and real income?

  • Nominal Income: Value of goods/services in current prices (no inflation adjustment).
  • Real Income: Adjusted for inflation to show actual purchasing power.
  • Real National Income is a more reliable indicator of economic performance, as it reflects actual growth in output and living standards.
• What is the circular flow of income concept?

  The circular flow of income represents how money moves through an economy:

  1. Households provide factors of production (labor, capital) to firms in exchange for income (wages, rent, interest, profits).
  2. Firms produce goods/services and sell to households, other firms, or the government.
  3. Government collects taxes and spends on services/infrastructure.
  4. Financial Sector channels savings into investment by businesses.
  5. Foreign Sector: Exports bring money into the economy, while imports leak money out.
• equation for circular flow of income

  The equation is: Income = Output = Expenditure. In equilibrium, income equals output and expenditure.
• What is equilibrium and full employment income in the circular flow of income?

  • Equilibrium: Occurs when total income equals total expenditure, with no unintended changes in inventories.
  • Full Employment Income: Refers to the level of national income where all factors of production are fully utilized. There’s no cyclical unemployment, and the economy is at its productive capacity.
• What is the difference between injections and withdrawals in the circular flow of income?

  • injections: Additions to the economy’s income flow, including:
  • Investment (I),
  • Government Spending (G),
  • Exports (X).
  • Withdrawals: Leakages from the economy, including:
  • Savings (S),
  • Taxes (T),
  • Imports (M).

  If injections exceed withdrawals, national income increases. If withdrawals exceed injections, national income decreases.
• What is aggregate demand (AD) and its components?

  Aggregate Demand (AD) is the total demand for goods and services in the economy at a given price level. It is composed of:

  AD=C+I+G+(X−M)\text{AD} = C + I + G + (X - M)AD=C+I+G+(X−M)

  • C = Consumption: Household spending on goods and services.
  • I = Investment: Business spending on capital goods.
  • G = Government Spending: Expenditure by the government.
  • (X - M) = Net Exports: Exports minus imports.
• What are the key determinants of Aggregate Demand (AD)?

  Consumption (C):

  • Income levels, interest rates, consumer confidence, and wealth effect.
  • Investment (I):
  • Interest rates, business confidence, government policy.
  • Government Spending (G):
  • Fiscal policy decisions on increasing or decreasing spending.
  • Net Exports (X - M):
  • Exchange rates, foreign income levels, and relative price levels.
• What is the accelerator process?

  The accelerator process suggests that changes in national income or demand can cause larger changes in investment. As income rises, businesses expect higher future demand and invest in capital goods, boosting economic growth and generating more income.
• What is the difference between saving and investment?

  • Saving: Income not spent on consumption, stored in financial assets (savings accounts, stocks, etc.).
  • Investment: Spending on capital goods (machinery, infrastructure) to increase future productive capacity.
• How do changes in net exports affect Aggregate Demand (AD)?

  • Increase in Exports: Boosts AD by increasing demand for domestic goods abroad.
  • Increase in Imports: Reduces AD as spending flows out of the domestic economy.
  • Exchange Rates: A weaker domestic currency increases exports and decreases imports, boosting AD.
• What is the multiplier effect in the economy?

  The multiplier effect describes how an initial increase in spending leads to a larger increase in national income. This occurs because the initial spending generates more income, which is then spent again, creating further rounds of income and spending.
• What is the Marginal Propensity to Consume (MPC)?

  The MPC is the fraction of additional income that is spent on consumption.

  • Multiplier = 1/(1-MPC)
  • A higher MPC leads to a larger multiplier effect.
• What are the key determinants of Short-Run Aggregate Supply (SRAS)?

  • Production Costs: An increase in wages or raw material prices shifts SRAS leftward.
  • Wages: Higher wages increase costs and reduce SRAS.
  • Raw Material Prices: Higher costs for raw materials reduce supply.
  • Productivity: Increased productivity shifts SRAS to the right, reducing costs.
• What causes SRAS to shift?

  • Rightward Shift: Lower production costs, increased productivity, or a reduction in wages/material prices.
  • Leftward Shift: Increased production costs, higher wages, or external shocks (e.g., rising oil prices).
• What determines Long-Run Aggregate Supply (LRAS)?

  • Technology: Technological advancements increase productivity, shifting LRAS rightward.
  • Productivity: More efficient labor and capital increase potential output.
  • Factor Mobility: Flexible movement of labor and capital across sectors boosts production.
  • Economic Incentives: Policies that encourage investment and innovation increase LRAS.
• Why is the LRAS curve vertical?

  The LRAS curve is vertical because, in the long run, output is determined by factors of production (labor, capital, technology), not by the price level. This reflects the economy’s potential output, or full capacity.
• What does the Keynesian Aggregate Supply (AS) curve represent?

  The Keynesian AS curve suggests that in the short run, the economy can operate below full capacity. As the economy expands, the curve becomes steeper. At full capacity, any increase in demand results in higher prices, not more output.
• How does the price level affect Short-Run Aggregate Supply (SRAS)?

  • In the short run, as the price level rises, firms are more willing to produce more goods and services because they can sell at higher prices while keeping costs fixed in the short run.
  • SRAS Curve: Generally slopes upward because higher prices incentivize firms to increase production.
• How does economic growth affect the Long-Run Aggregate Supply (LRAS)?

  • Economic Growth shifts the LRAS curve to the right.
  • Economic growth increases an economy’s productive capacity by improving factors such as technology, labor quality, capital accumulation, and entrepreneurship.
  • The rightward shift in LRAS represents an increase in the economy’s potential output, leading to higher standards of living and increased national income.
• What happens to Aggregate Demand (AD) when the price level changes?

  • A decrease in the price level increases the purchasing power of consumers and leads to an increase in consumption, shifting AD to the right.
  • An increase in the price level decreases the purchasing power of consumers and leads to a reduction in consumption, shifting AD to the left.
  • This relationship is represented as a movement along the AD curve, not a shift of the AD curve.
• What factors can shift the Aggregate Demand (AD) curve?

  • Consumption (C): Changes in consumer confidence, disposable income, or wealth.
  • Investment (I): Changes in interest rates, business expectations, and government policy.
  • Government Spending (G): Fiscal policy (e.g., changes in government spending or taxation).
  • Net Exports (X - M): Changes in exchange rates, foreign income, and trade policies.
• What is the difference between the Keynesian and Classical Aggregate Supply (AS) curves?

  • Keynesian AS Curve: In the short run, it is flat or nearly horizontal, meaning increases in AD can raise output without increasing prices (unused capacity).
  • Classical AS Curve: It is vertical at the full-employment level of output, indicating that increases in AD only lead to higher prices, not more output, once the economy reaches its capacity.
• How does an increase in the price level impact the Short-Run Aggregate Supply (SRAS)?

  • An increase in the price level increases output in the short run because higher prices make it more profitable for firms to produce goods and services.
  • However, this is only possible if firms’ costs (e.g., wages and materials) remain constant or increase slower than the price level.
• What are the main factors that cause the Short-Run Aggregate Supply (SRAS) curve to shift?

  • Changes in wages: If wages rise, production costs increase, shifting SRAS left.
  • Changes in raw material prices: Higher material costs reduce supply, shifting SRAS left.
  • Changes in business taxation: Increased taxes on businesses raise costs and shift SRAS left.
  • Changes in productivity: Improvements in productivity lower costs and shift SRAS right.
• What is a supply-side shock, and how does it affect the economy?

  • A supply-side shock is an unexpected event that suddenly increases or decreases the supply of goods and services, such as a natural disaster, oil price spike, or technological innovation.
  • A negative supply-side shock (e.g., a rise in oil prices) can shift the SRAS curve to the left, reducing output and increasing prices (stagflation).
  • A positive supply-side shock (e.g., a technological breakthrough) can shift the SRAS curve to the right, increasing output and reducing prices.
• How does the multiplier effect influence economic activity?

  • The multiplier effect occurs when an initial increase in spending leads to a larger increase in national income.
  • For example, if the government spends on infrastructure, workers and contractors receive income, which they then spend, generating more income and further stimulating the economy.
  • The size of the multiplier depends on the Marginal Propensity to Consume (MPC)—a higher MPC leads to a larger multiplier.
• How does government spending affect Aggregate Demand (AD)?

  • Increase in government spending (G) shifts AD to the right.
  • Government spending directly increases the demand for goods and services in the economy, stimulating economic growth and potentially reducing unemployment.
  • Decreased government spending shifts AD to the left, potentially leading to lower output and higher unemployment.
• How do interest rates affect Aggregate Demand (AD)?

  • Lower interest rates reduce the cost of borrowing, which encourages consumers to spend and businesses to invest, shifting AD to the right.
  • Higher interest rates increase borrowing costs, which reduces consumer spending and business investment, shifting AD to the left.
• How do changes in exchange rates affect net exports (X - M)?

  • A depreciation of the domestic currency makes exports cheaper for foreign buyers, increasing demand for domestic goods and services. This shifts AD to the right.
  • An appreciation of the domestic currency makes exports more expensive and imports cheaper, reducing net exports and shifting AD to the left.
• What is the difference between demand-side and supply-side shocks?

  • Demand-Side Shocks: Affect aggregate demand (AD), such as changes in consumer confidence, fiscal policy, or global economic conditions. They lead to shifts in the AD curve.
  • Supply-Side Shocks: Affect aggregate supply (AS), such as changes in the price of raw materials, labor, or technology. They lead to shifts in the SRAS curve.
• What happens when there is a positive demand-side shock?

  • A positive demand-side shock (e.g., increased consumer confidence, government stimulus) boosts overall demand.
  • This causes the AD curve to shift right, leading to higher national income, reduced unemployment, and potential inflationary pressures.
• How does the AD-AS model relate to full employment?

  • In the AD-AS model, the economy is at full employment when the AD curve intersects the Long-Run Aggregate Supply (LRAS) curve at the natural level of output.
  • At full employment, the economy produces at its potential output, and cyclical unemployment is eliminated.
  • Any increase in AD above full employment can lead to inflation, not more output.
• How does inflation affect the Short-Run Aggregate Supply (SRAS) curve?

  • Demand-pull inflation: Caused by an increase in AD, pushing prices up and causing firms to increase production. This leads to a movement along the SRAS curve.
  • Cost-push inflation: Caused by increases in production costs (e.g., wages, raw materials), shifting the SRAS curve to the left.
• How does technological progress affect Long-Run Aggregate Supply (LRAS)?


  • Technological improvements increase productivity and the capacity of firms to produce goods and services.
  • This shifts the LRAS curve to the right, increasing potential output and improving the economy’s productive capacity.
• What is national income?

  Total value of new output over time
• What produces the output in an economy?

  Physical and human capital
• How does income differ from wealth?

  Income is a flow; wealth is a stock
• What are the two types of GDP used to measure national income?

  Nominal and real GDP