NATIONAL INCOME

• Circular flow of income

  The most basic form of the model shows a two-sector economy: with just the households and the sellers
• Participants in the circular flow of income

  • Households
  • Firms
• Households


  Own all the wealth and resources so provide the firms with land, labour and capital in return for rent, wages, interest and profits
• Firms


  Produce goods and services that households buy
• Money flow


  Flows in one direction (represented by green arrows)
• Goods, services and factors of production flow


  Flow in another direction (represented by orange arrows)
• Ways of measuring the level of economic activity


  • National output
  • National expenditure
  • National income
• In the simple two-sector model, national output=national expenditure=national income
• Two-sector model


  • Too simplified to represent the actual economy
• Additions to the two-sector model

  • Government
  • Financial services
  • Foreign markets
• Injections


  Monetary additions to the economy: government spending, investment, exports
• Withdrawals/Leakages


  Money removed from the economy: taxes, savings, imports
• If the sum of injections is greater than the sum of leakages/withdrawals, the economy will be growing. If injections are smaller than withdrawals, it will be shrinking.
• In an equilibrium, injections must be equal to withdrawals and so the national income remains the same.
• Equilibrium level of real national output

  Where the AD and AS curves intersect
• If AS or AD are shifted


  The equilibrium position will change
• Short-term classical view


  • AD is downward sloping, AS is upward sloping
• Increase in SRAS


  Leads to fall in price level and increase in real GDP
• Increase in AD


  Leads to higher prices and higher real GDP
• Long-term classical view


  • LRAS is perfectly inelastic, so a shift in AD only affects price levels, not output
• Increase in AD


  Leads to higher prices but no change in output in the long run
• Keynesian view


  • LRAS can have equilibrium at less than full employment
• Increase in AD when economy is in deep recession


  Increases output but not price
• Increase in AD when economy is near full employment


  Increases price but not output
• Keynesians argue that during recessions, the government needs to increase AD rather than using supply-side policies
• A factor that affects AD can also affect AS
• Multiplier process


  An increase in AD because of an increased injection can lead to a further increase in national income
• Multiplier ratio


  The ratio of the final change in income to the initial change in injection
• Marginal propensity to consume (MPC)


  The increase in consumption following an increase in income
• Marginal propensity to withdraw (MPW)

  The increase in leakages following an increase in income (MPS + MPT + MPM)
• The higher the MPC, the bigger the multiplier
• An increase in any of the marginal propensities to withdraw will decrease the MPC
• For the multiplier to have the desired effect, there must be sufficient spare capacity in the economy
• The more elastic the AS curve, the smaller the effect of the multiplier on price but the bigger the effect on output
• The multiplier has a big effect when there is plenty of spare capacity in the economy and the MPW is low/MPC is higher