(2.4) National Income

• Circular flow of income

  1. Households own wealth and resources, provide firms with land, labour and capital in return for rent, wages, interest and profits

  2. Households use this money to buy goods and services produced by the firms

  3. Money flows in one direction, goods/services and factors of production flow in another

  
• National output


  Value of the flow of goods and services from firms to households
• National expenditure


  Value of spending by households on goods and services
• National income


  Income paid by firms to households in return for land, labour, capital and enterprise
• In the simple two-sector model, national output=national expenditure=national income
• Two-sector model


  • Too simplified to represent the actual economy
• Expanded circular flow model


  1. Government takes money through taxation and adds money through spending

  2. Financial services inject money through investment and take money away through savings

  3. Foreign markets add money through exports but take money away through imports
• Wealth


  Stock of assets
• Income


  Flow of money
• Countries with high levels of wealth tend to have high levels of income and vice versa but there is not a perfect correlation between wealth and income
• Injections


  • Government spending (G)
  • Investment (I)
  • Exports (X)
• Withdrawals/Leakages


  • Taxes (T)
  • Savings (S)
  • Imports (M)
• If sum of injections is greater than sum of withdrawals


  Economy will be growing
• If injections are smaller than withdrawals


  Economy will be shrinking
• In equilibrium, injections must be equal to withdrawals and so the national income remains the same
• Equilibrium position of national output

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


  Equilibrium position will change
• In the short run, AD is downward sloping and AS is upward sloping
• Short-run equilibrium changes


  1. Increase in SRAS shifts equilibrium to lower prices and higher real GDP

  2. Increase in AD shifts equilibrium to higher prices and higher real GDP
• Classical LRAS


  • Perfectly inelastic, so shift in AD only affects prices not output
  • Economy will always return to full employment level
• Classical long-run adjustment


  1. Increase in AD leads to positive output gap

  2. Firms bid up wages and other factor prices

  3. SRAS shifts to higher prices, output returns to original level
• Classicists conclude that changes in AD without a change in LRAS are only inflationary
• Rise in LRAS


  Leads to lower prices and higher output
• Classical economists favour supply-side policies over demand management
• Keynesian LRAS


  • Can have equilibrium at less than full employment
  • Believe wages don't rapidly fall with unemployment
• Keynesian long-run adjustment


  1. Increase in AD from deep recession only increases output, not prices

  2. Increase in AD from near full employment increases prices, not output
• Keynesians argue government needs to increase AD during recessions, not use supply-side policies
• In macroeconomics, a factor affecting AD can also affect AS
• If the economy is producing at or near full employment, for example at AD1


  A rise in LRAS will increase output and decrease the price level
• If the economy is in a deep recession, for example producing at AD2


  An increase in LRAS will have no effect on prices or output
• Keynesians argue that during recessions the government needs to work to increase AD rather than using supply side policies
• In microeconomics, any factor which affected demand would not affect supply and vice versa
• With macroeconomics, a factor which affects AD can easily affect AS
• An increase in investment


  Increases AD but it could also increase LRAS as firms are able to produce more
• Not all investment results in increased production and so the LRAS will not increase
• The extent to which investment increases output and lessens inflation depends on its rate of return
• Multiplier process


  An increase in AD because of an increased injection (exports, government spending or investment) 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
• Multiplier process


  1. Initial injection increases spending and income for someone else

  2. This leads to further consumption spending

  3. This creates more jobs and increases output
• Marginal propensity to consume (MPC)


  The increase in consumption following an increase in income