Podcast
Questions and Answers
What primary factor primarily drives the circular flow of income model?
What primary factor primarily drives the circular flow of income model?
- Demand-side fluctuations (correct)
- Government policies
- Investment levels
- Supply-side considerations
How does an increase in the general price level affect aggregate demand?
How does an increase in the general price level affect aggregate demand?
- It has no impact on aggregate demand
- It only affects a specific sector of the economy
- It increases aggregate demand through higher investment
- It decreases aggregate demand due to a fall in purchasing power (correct)
What effect does the erosion of financial wealth have on consumption?
What effect does the erosion of financial wealth have on consumption?
- It has no significant effect
- It stimulates investment in financial markets
- It depresses consumption as people withdraw savings (correct)
- It encourages increased spending
What happens to the aggregate demand curve if consumers decide to spend more?
What happens to the aggregate demand curve if consumers decide to spend more?
Which of the following best describes the relationship modeled by the aggregate supply curve?
Which of the following best describes the relationship modeled by the aggregate supply curve?
What is a potential impact of rising interest rates in the context of aggregate demand?
What is a potential impact of rising interest rates in the context of aggregate demand?
Which effect suggests that higher prices lead to increased imports due to reduced domestic purchasing?
Which effect suggests that higher prices lead to increased imports due to reduced domestic purchasing?
In the short run, what is the expected behavior of total supply as prices increase?
In the short run, what is the expected behavior of total supply as prices increase?
What happens to profit when output prices increase, assuming certain factors remain constant?
What happens to profit when output prices increase, assuming certain factors remain constant?
How may the marginal cost of additional output be affected by the existing levels of output?
How may the marginal cost of additional output be affected by the existing levels of output?
Which factor may cause prices of inputs to rise more slowly than prices of final goods and services?
Which factor may cause prices of inputs to rise more slowly than prices of final goods and services?
What is the consequence of a positive output gap when the AD curve shifts to the right?
What is the consequence of a positive output gap when the AD curve shifts to the right?
What leads to a negative output gap when the AS curve shifts left?
What leads to a negative output gap when the AS curve shifts left?
What conditions lead to the AS curve shifting when potential output rises?
What conditions lead to the AS curve shifting when potential output rises?
What best describes the situation when the supply has a lot of slack?
What best describes the situation when the supply has a lot of slack?
Which of the following best represents the main challenge for firms and workers in predicting price level changes?
Which of the following best represents the main challenge for firms and workers in predicting price level changes?
Flashcards
Demand-driven model limitation
Demand-driven model limitation
The circular flow model focuses entirely on demand, neglecting the vital role of supply in firms' production decisions.
Aggregate Demand Curve
Aggregate Demand Curve
The aggregate demand (AD) curve shows the total demand for goods and services in an economy at different price levels. It slopes downwards, meaning that as prices rise, total demand falls.
Income effect on AD
Income effect on AD
When prices rise, real incomes decrease because wages often don't adjust at the same pace, reducing consumer spending.
Substitution effect on AD
Substitution effect on AD
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Real balance effect on AD
Real balance effect on AD
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Inter-temporal substitution effect on AD
Inter-temporal substitution effect on AD
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International Substitution Effect on AD
International Substitution Effect on AD
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Aggregate Supply Curve
Aggregate Supply Curve
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Sticky Prices
Sticky Prices
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Short-Run Supply Response
Short-Run Supply Response
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Short-run Profit Maximization
Short-run Profit Maximization
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Steepest Point on the Supply Curve
Steepest Point on the Supply Curve
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Positive Output Gap
Positive Output Gap
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Negative Output Gap
Negative Output Gap
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Increasing Potential Output
Increasing Potential Output
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Supply Slack
Supply Slack
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Study Notes
Limitations of the Circular Flow of Income Model
- The model focuses on the demand side, but supply is equally important for firms' output
- It doesn't account for firms' supply decisions
- Changes in aggregate demand impact both output and prices
Aggregate Demand Curve
- Examines the relationship between total demand for goods/services and average price levels
- Uses GDP deflator to measure overall price levels, not just individual products
- Aggregate demand decreases as prices increase
Income Effect
- Real incomes decline when prices rise because wages often don't adjust as quickly
- Reduced consumer spending leads to a decrease in aggregate demand
- Potential offset by increased profits (leading to increased investment), but this is unlikely due to reduced demand. Increased dividend payments for shareholders may partially counteract.
Substitution Effect
- Real balance effect (wealth effect): Erosion of financial wealth due to rising prices reduces consumption. Savings are worth less, so people withdraw more from savings accounts to maintain their savings' worth.
- Inter-temporal substitution effect (interest effect): Higher prices lead to increased demand for money, resulting in higher interest rates, discouraging spending and encouraging saving. Investment decreases due to higher borrowing costs.
- International substitution effect (net exports effect): Higher domestic prices make domestic goods less competitive internationally, leading to increased imports and reduced exports.
Shifts in Aggregate Demand
- Positive demand shock (increase in consumer spending, investment etc) shifts the curve rightwards
- Negative demand shock (decrease in consumer spending, investment etc) shifts the curve leftwards
Aggregate Supply Curve
- Models the relationship between firms' output and the overall price level
- Output increases as prices increase in the short run due to increased profit margins
- Marginal costs may increase with higher output levels
- Availability of factors of production (labour, resources) influences production capacity, affecting the steepness of the AS curve.
- Diminishing returns affect aggregate output and costs more steeply at higher production levels
- Price changes in final goods/services affect input prices like wages/resources. This can impact AS curve responsiveness to changes in price
Long-Run Aggregate Supply (LRAS)
- Determined by factors like the labour force, capital stock, and technological advancements
- Price levels do not affect LRAS in the long run
- Shifts in LRAS are driven by changes in factors like technology, labour force, or capital investment. Short run supply is more responsive/reactive to changing conditions compared to LRAS.
Increase in Aggregate Supply
- Scenario 1: Increasing supply at each price level up until full capacity, driven by factors like lower wages or input costs
- Scenario 2: Potential output increases due to factors like increased production capacity, technological improvements, or more human capital.
Equilibrium
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When aggregate demand (AD) shifts right, output increases and equilibrium moves towards a positive output gap and higher prices
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When AD shifts left, output and employment fall; this results in a negative output gap and reduced prices.
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When AS shifts left, there is reduced output and higher prices.
Keynesian Model Integration
- Combining AS/AD and Keynesian models shows the impact of demand shifts on national income. Changes in aggregate demand lead to shifts in the 45° line and AS/AD diagrams
Unemployment and Inflation
- Deflationary gap (excess capacity): Withdrawal exceed injections at full employment level of national income.
- Inflationary gap (excess demand): Injections exceed withdrawals at full employment.
Other Points
- Firms adjust prices and wages slowly due to menu costs (costs of changing prices) and wage rigidity.
- Shifts in AS curves result from changes in available labour and capital.
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Description
Explore the limitations of the Circular Flow of Income model and its implications for aggregate demand and supply dynamics. Understand how changes in prices affect consumer spending and the overall economy, including the impact of the income and substitution effects.
