Aggregate Supply, Macroeconomic Equilibrium, The Economic Cycle, Economic Growth, Circular Flow and Measuring National Income

CIRCULAR FLOW

The circular flow shows the flows of goods and services and incomes to factors of production. Shows how national income or GDP can be calculated Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) Injections into the circular flow are  Investment spending Exports of goods and services Government spending Leakages (withdrawals) from the circular flow are  Savings in bank accounts Taxation e.g. income tax and national insurance Imports e.g. spending on foreign goods and services  These lead to a multiplied contraction of production (output)Macroeconomic equilibrium is when rate of injections is equal to the rate of withdrawals. 

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MEASURING NATIONAL INCOME

National income measures the monetary value of the flow of output of goods and services produced in an economy over period of time. It measures the rate of economic growth, changes to living standard & distribution of income. Gross domestic product (GDP) is the total value of output produced in a given time period. It includes the output of foreign owned businesses that are located in a nation following foreign direct investment. e.g. Nissan car plantsNational output = National expenditure (AD) = National IncomeSo GDP = AD = C + I + G + (X-M)  GDP = Income from people in jobs and self employment + Profits of private sector businesses + Rent income from ownership of land.We exclude from the calculation Transfer of payments e.g. state pension, JSA etc.  Private transfers of money e.g. remittances Income not registered with tax authorities (shadow economy) Purchasing Power Parity (PPP) measures how much one country's currency is needed to buy the same basket of goods and services with another country's currency. 

Gross Value Added and Contributions to a nation's GDP measures the value of output produced by each of the productive sectors in the economy using the concept of value added. Value added is the increase in the value of goods or services as a result of the production processValue added = value of production - value of intermediate goodsGross National Income (GNI) measures the final value of incomes flowing to UK owned factors of production whether or not they are located in the UK or overseas. It is is concerned only with the incomes generated within the geographical boundaries of the country. GNI = GDP + Net property income from abroad (NPIA)NPIA is a balance of interest, profits and dividends coming into the UK from assets abroad. Remittances are transfers of money across national boundaries by migrant workers. Nominal income is monetary values for data, not inflation adjusted and is expressed at current pricesReal Income is adjusted for inflation, prices are held at the level of the chosen base year and data is expressed at constant prices.

SHORT RUN AGGREGATE SUPPLY

Aggregate supply (AS) measures the volume of goods and services produced each year. AS represents the ability of an economy to deliver goods and services to deliver this demand. Short run AS (SRAS) shows total planned output when prices can change, but the prices and productivity of factor inputs are held constant. It is an upward sloping curve.Causes for shifts in the AS curve are: Changes in unit labour costs if there is a change in productivity. Changes in other production costs e.g. rental costs for retailers. Commodity prices can change the costs of production Exchange rate appreciation (or depreciation) can cause costs of imported raw materials to change.  Government taxation causes higher costs Government subsidies cause lower costs Short run shocks to production e.g. hurricanes

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LONG RUN AGGREGATE SUPPLY

Classical Long run AS (LRAS) shows total planned output when prices and average wage rates can change - it measures the country's potential output (like PPF). It is a vertical line.Trend growth is the estimated rate of growth of a nation's productive potential. Productivity measures the efficiency of the production process. In the long run, productivity is a major determinant of economic growth and of inflation. A fall in labour productivity leads to a rise in a firms unit costs of productionHigher productivity allows businesses to pay higher wages and achieve increased profits. Non linear (Keynesian) AS curve shows that when spare capacity is high then SRAS will be elastic and a  rise in AD can be easily achieved by increasing output with little effect of rising inflation. The elasticity of SRAS falls as output increases and the amount of spare capacity declines leading to shortages. 

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MACROECONOMIC EQUILIBRIUM

Macroeconomic equilibrium is when AD intersects with SRAS. If the general price level is too high, there will be an excess supply of output and producers will have unsold stocks and will cut back on production. If the price level is above equilibrium, there is excess demand in the short run so businesses should expand output. For an economy to be in equilibrium, total demand for goods and services is close to the actual level of production.Increase in AD (right shift) causes a cyclical increase to employment and output. The price level will increase and GDP will increase. An increase in SRAS (left shift) causes expansion of AD and higher equilibrium level of national output causing more GDP and inflation will fallA fall in AD (left shift) causes lower equilibrium level of national output, a decrease in inflation and a decrease in real GDP. A fall in SRAS (right shift) due to higher production costs, causes contraction of AD, lower equilibrium of national output, an increase in inflation and a decrease in real GDP. 

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THE ECONOMIC CYCLE

The output gap is measure of the difference between actual output and potential output. A negative output gap occurs when actual output is less than potential output. This is also known as a deflationary gap. There will be unemployment, low growth, low inflation (or deflation) in an economy. A positive output gap occurs when actual output is greater than potential output. This occurs when economic growth is above the long run trend rate. Demand-side Shocks such as economic downturn in a trading partner, unexpected tax increases can cause output gap to increase. Supply side shocks such as a steep price increasing of commodities or strikes can cause the output gap to increase. Recessions can be caused by: External events e.g. a recession in a trading country, rise in global commodity prices Tightening of fiscal macro policy e.g. higher interest rates, rise in taxation

Fall in asset prices or supply of credit e.g. a steep decline in house prices, collapse in supply of credit  Drop in business and consumer confidence e.g. lower business confidence means less investment and more unemployment, low consumer confidence leads to less spending and more saving.  Short term effects of a recession are Unemployment Budget deficit Deflation  Less investment  Long term effects of a recession are  Structural unemployment / regional decline Reduction of capital stock Fiscal deficit - more austerity Real wages fall Inequality rising Social costs such as less social cohesion

HYSTERISIS AND CREATIVE DESTRUCTION

Hysteresis When an economy is disabled by a recession there is a big risk of a permanent loss of national output. Loss of productive capacity due to low capital investment + many business closures. High rates of structural unemployment may cause a shrinking labour force perhaps through outward migration. Creative destructionRecessions can cast a dark shadow but capitalist market economies usually bounce back eventually. Recessions prompt the emergence of ew business models and an increase in start-ups. New technologies can act as a catalyst for renewed economic growth and investment. A depression is a prolonged slump over a number of years where real GDP falls by 10%

MULTIPLIER AND ACCELERATOR EFFECTS

The multiplier effect is when an initial change in AD can have a greater final impact on the level of equilibrium national income (GDP) due to injections of new demand for goods and services into the circular flow of income, leading to more spending, leading to a an expansion of output, income and profit. Positive multiplier is when an initial increase in an injection (or a decrease in a leakage) leads a to a greater final increase in real GDP. Negative multiplier is when an initial decrease in an injection (or a increase in a leakage) leads to greater final decrease in real GDPThe multiplier = 1 / (1-MPC) The multiplier effect will be larger when  The MPC is great, and MPS is low Marginal rate of tax is low MPC of domestic goods and services is high Consumer confidence Businesses have the capacity to expand production to meet increases in demand.

The multiplier effect will take time to come into full effect as there is a time lag. The multiplier effect is seen as a demand-management approach designed to help overcome a shortage of capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment. 

ECONOMIC GROWTH

Economic growth is a long-term expansion of productive potential. Short term growth is the annual percentage change in real national output. Factors that affect short term economic growth are Interest rates Fiscal policy Commodity prices Exchange rates Trading conditions Confidence