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Income Flows and Wealth Effects
· Shown in the circular flow of income, households hold all the factors of production and the firms are
the producing units. Money moves from households as payment for the use of the factors of
production in the form of rent, wages, interest and profit. Money circulates from households to firms
and back again as the more households spend, the more firms produce. The income and output of the
economy should always be the same and they are measured in GDP
· The multiplier effect is the number of times a change in income exceeds the change in net injections. It
is the knock on effect on incomes when injections and withdrawals change. The importance of the
multiplier is that the result on income will be greater than the initial input. The formula is based on
how much of any extra pound earned is re-spent within the economy which is the marginal
propensity to consume. In developing countries, the multiplier is often higher which explains higher
· If all injections equal all the leakages, then the economy will be in equilibrium; if injections are greater
than leakages, the economy will grow; and if leakages are greater than injections, the economy will
· Wealth is the sum of all the assets in the economy. Wealth is is often held in the form of housing,
stocks and shares
· Wealth is a stock concept and income is a flow concept. This means that wealth does not have a
direct impact on the circular flow of income, but changes in wealth are likely to have an effect on
incomes and spending.
· Some examples include;
- If you live in a property that increases in value, you may feel more confident about spending in the
economy which will therefore becoming a part of the circular flow of income.
- If housing becomes more expensive, loans will increase and once spent will also contribute to an
increase in the circular flow of income.
- When capital markets take a downturn in the US, people in the UK might find that their incomes fall
because dividends on pension funds are often based on capital gains of shares…read more
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Aggregate Demand and Supply
Aggregate Demand The total planned expenditure on goods and services produced in the
UK. At higher price levels, interest rates are likely to be raised by the monetary authority.
This means investment (a component of AD) will fall and savings may increase.
AD = Consumption + Investment + Government
Spending + (Exports Imports).
Consumption Spending on goods and services
(65% of AD). It is mainly influenced by the
confidence of the consumer.
Investment This is influenced by interest rates,
high interest means that investment will be
reduced because it costs more to lend.
Government Spending This increases in
economic downturn as it kick starts the
economy, it need not always = tax revenue as
the gov lend money creating a budget deficit.
This can work the other way round in a boom if
there is no national debt.
Net Exports Exchange rates influence this heavily as a strong pound leads to increased
imports and reduced exports and vice versa.
Aggregate Supply The amount firms are willing to produce at various price levels. It is
large influenced by productivity,.
· Long run AS shows that all resources are deployed and there is full employment, this
can be show with a PPF curve, a vertical AS curve or the Keynesian J shape.
· Short run AS is displayed by the standard supply curve.
Shifts in AS can occur due to changes in the labour + product market
Labour Market Product Market
Productivity gap closes Output per Sources of raw materials change As
unit of input, if this ratio increases competition increases, prices fall
relative to trading partners, it indicates Exchange rates fall If the pound was strong
that the productivity gap is closing and it it would lead to cheap imports
is becoming cheaper International trade increases Competition
Education and skills improve drives down prices and ineffective domestic
Increased spending on education means businesses lose out as they don't have
the workforce can potentially produce comparative advantage.
more. Technological advances reduces costs for
Health spending increases Workers firm/increases output
have less days off and can work for Regulation change Deregulation leads to
longer increased competition and reduced prices…read more
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Economic Growth Causes, Constraints and Costs
· Actual Growth can be defined by an increase in real GDP. This can be caused by an increase in a
component of AD or an increase in AS due to a fall in production costs. A shift of AS or AD to the right
indicates actual economic growth.
· Potential Growth can be defined by an increase in capacity. This can be only be caused by a shift to the
right of the vertical part of the AS curve, increasing the amount the economy can produce. This can also
be displayed by a shift to the right of the PPF curve
· GDP tends to fluctuate in certain times, during a boom, it rises rapidly but during a recession it falls for
at least 2 consecutive quarters. During a slowdown, GDP may still rise but under the trend or may fall.
Constraints on growth
· Absence of capital markets lt may be less credible and efficient due to asymmetric information
where the lender knows little about the borrower, making a missing market as there isn't a equilibrium.
· Government instability Investment is typically less likely in countries who are poorly led as they may
have large fiscal deficit meaning reduced spending power to encourage growth. (or war for example)
· Labour market problems As GDP grows, birth rates fall leading to low labour supply which leads to the
import of labour which can create the same problem in low income countries
· External constraints Volatility in exchange rates, uneven access to world trade, global recession, fear
of terrorism can all constrain growth
Benefits of growth
· Employees Incomes and wealth rise when economic growth occurs, standards of living rise as costs of
living don't rise at the same rate.(Real growth means an increase in Real income).
· Firms Profit increases when economic growth occurs as spending often rises, meaning more is sold.
This allows firms to take on more workers and invest, increasing future growth prospects.
· Governments When income and assets prices increase, the government gets more tax revenue and
also have reduced unemployment benefits to pay. This allows them to be in a healthier fiscal position.
Costs of growth
· Income equality The unwaged or unskilled are unlikely to benefit from increased income.
· Environmental problems Depletion of natural resources and external costs such as carbon emissions
tend to increase with economic growth.
· Balance of payments Higher incomes result in increased imports, reducing the incentive for firms to
export causing an imbalance. However, if the economy is export led, the current account would improve
· Bottlenecks in the economy Little spare capacity leads to an increase in price of skilled labour and
fuel. Monopolies may also develop, creating a barrier for new firms (shown by increased inelastic AS)
· Social dislocation Higher incomes must be earned, which may lead to stress and increased hours.
However, as more money is being earned, it may lead to reduced hours and more luxury time.
· Problems of rapid growth May lead to a short term price spike and if a country grows too quickly it
may lead to corner cutting and bad planning .
· The difference between actual output and potential output
is called the Output Gap.
· If the economy is growing quicker than the trend, it puts
pressure on the tight labour markets, wages and shortages
of materials, creating a positive output gap potentially
leading to raised interests rates. If the economy is growing
below the trend , there is likely to be spare capacity,
creating a negative output gap which may lead to reduced
interest rates…read more
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Main Objectives Additional Objectives
· Stable economic growth · Sustainable environment
· Keep inflation at a forecasted rate (2% in UK) · Improved education
· Reduce unemployment · Reduce public deficit balanced budget
· Restore equilibrium in the balance of payments · Reduce inequality in wealth and income
· Raise living standards · Increased satisfaction and wellbeing
· Improve stability of currency
Conflicts between objectives
Inflation vs. Reduced Unemployment
· As more people come into jobs, spending increases which in turn
results in an increase in inflation. The Phillips Curve is a observation
that there is a negative correlation between inflation (via wages
Economic growth vs Equilibrium in the balance of payments
· As an economy grows, income rises so consumers are likely to demand more imports and incentive to export
diminishes, as it becomes easier to find customers in the domestic market therefore economic growth is likely to
worsen the current account.
· Export-led growth differs from this as the driving component of growth is the export component of AD, meaning
the balance of payments will improve as more exports are being sold.
· Improve education
· An increase in aggregate supply also wouldn't worsen the balance. If there is a decrease in costs or an increase in
investment, an economy will increase it's competitiveness, meaning it will be able to export more and import less
· Reduce public deficit achieving balanced budget
· Reduce inequality
Additional Objectivesin wealth and income
Reduced unemployment vs. Sustainable environment
· If Increased
more workers satisfaction
are being employed, and wellbeing
there is likely to be more congestion and increased production
· which will result
Reduce in a higher
public level of
achieving balanced budget
· As incomes increase, holidays abroad also rise and travelling to these places increase pollution
· Higher inequality
employment in wealth
can also mean increased and income
tax revenue which can be used to clean up the
· Increased satisfaction and wellbeing which are used to reduce carbon emissions
environment. Also as a spin off, there may be `green taxes'
Economic growth vs. Equality of income distribution
· When an economy grows, incomes are likely to rise at the top end of the spectrum. The effect being the
widening of income inequality.
· Over time, higher incomers are likely to employ more people (domestic staff), increasing demand for
low skilled labour and eventually raising incomes.
· As skill shortages develop, immigration fills the gap and the wages of low skilled workers do not rise.
Inflation vs. Equilibrium in the balance of payments
· Low inflation means the prices of products are more competitive against other countries, meaning
exports will increase and imports become less attractive.
· Control of inflation will not correct a surplus in balance of payments and won't restore equilibrium in
the sense of removing a surplus.
· Inflation control may lead to tight interest rates. Interest rates effect the exchange rate, a strong
currency makes a countries exports less attractive and imports cheap hence worsening the trade
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Policy Instruments Supply Side
Supply side policies are government policies that increase the amount of 'supply' that is capable of being produced
over the long term. They improve the productive potential of the economy. Diagrammatically, it can be illustrated by
an outward shift in the production possibility frontier (PPF)
Product market supply side policies
All of the policies in the product market are designed to increase competition, and so efficiency. If the productivity of
an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve
to the right.
Privatisation - The privatisation of various large industries (telecommunications, electricity, gas, etc.) was
designed to break up state monopolies to create more competition. Of course, many of these simply turned public
sector monopolies into private sector monopolies, but there have been efforts to introduce competition into these
Deregulation This is the freeing of regulation, often government regulation which often allows reduced costs
and increased supply.
Help for businesses - In particular, small businesses. The governments of the 80s encouraged enterprise with
various grants, reductions in small business tax rates and tax breaks for investment.
Labour market supply side policies
The following policies are all designed to improve the quality and quantity of labour. Increased numbers will
obviously increase the productive potential of an economy. LRAS curve will shift to the right
against trade unions - Trade unions are a barrier to the free working of a labour market. They stop
employers from negotiating the wage individually with employees and arriving at the equilibrium wage. Unions
to push thepublic
wage abovedeficit achieving
the market balanced
equilibrium. Reducing the powerbudget
of trade unions make labour markets
flexible and efficient. in wealth and income
Education and training - Government spending on education and training improves workers' human capital. They
better quality workers so theirand wellbeing
productivity improves. It should also be noted that improved training,
especially for those who lose their job in an old industry, will improve the occupational mobility of workers in the
Income tax rates - Many felt that high tax is a disincentive to work in the labour market. Why work harder if the
government will keep most of your earnings? The government reduced these high marginal income tax rates to
encourage more people to work hard. However, when direct taxes drop, indirect taxes rise to make up for it ; but
the point was to get more people to be economically active, and those already in work might work harder.
Unemployment benefits - In some countries where government spending is relatively high, unemployment
benefits are so high that the difference between disposable income in work and benefits received out of work is
small. There is little incentive to take a job. Whether out of work benefits are reduced or in work benefits are
increased, the idea is to create incentives for people to work and so increase the supply of labour and the
productive potential of the economy.…read more