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 money to buy goods and services produced by 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
• Additions to the 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
• The size of the change in equilibrium will depend on the size of the shift and the elasticity of the curve which has not moved
• Short term


  • AD is downward sloping, AS is upward sloping
• Short term equilibrium change

  1. Increase in SRAS shifts equilibrium from P1Y1 to P2Y2, with lower prices and higher real GDP

  2. Increase in AD shifts equilibrium from P1Y1 to P2Y2, with 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, no unemployment in long run
• Classical long term equilibrium change

  Increase in AD shifts short term equilibrium to P2Y2, but long term equilibrium returns to P1Y1 with higher prices but same output
• The only way to increase output in the long run for classicists is to increase LRAS
• Increase 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, as they don't believe a rise in unemployment rapidly leads to a fall in real wages
• Keynesian long term equilibrium change

  1. Increase in AD from AD1 to AD2 only increases output not prices, shifting equilibrium from P1Y1 to P1Y2

  2. Increase in AD from AD3 to AD4 is purely inflationary, shifting equilibrium from P2Y3 to P3Y3
• With a Keynesian curve, the impact of a shift in AD strongly depends on the elasticity of the curve, and hence whether the economy is at or near full employment
• During recessions, Keynesians argue the government needs to work to increase AD rather than using supply side policies
• In macroeconomics, a factor which affects AD can easily 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. However, with macroeconomics, a factor which affects AD can easily affect AS
• The extent to which investment increases output and lessens inflation depends on its rate of return
• Multiplier process


  The idea that 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; and the figure multiplied by the original injection to find the final change in income
• 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
• Marginal propensity to save (MPS)


  The increase in savings following an increase in income