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How the Economy Works

How the Economy Works. Think of a bathing tub. To satisfy people’s wants, goods ands services are produced by using FoPs. Fops are used in return of an income. Land = Rent Labour = Wages/Salary Capital = Interest Entrepreneur = Profit

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How the Economy Works

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  1. How the Economy Works

  2. Think of a bathing tub

  3. To satisfy people’s wants, goods ands services are produced by using FoPs. • Fops are used in return of an income. Land = Rent Labour = Wages/Salary Capital = Interest Entrepreneur = Profit • The total amount of output produces in an economy with Factors of Production is known as the National Output. • Total amount of income earned in an economy is the National Income.

  4. The Economic Mechanism Exercise 1

  5. A simple model of an economy • Assumption – no govt, no foreign trade • Only private sector exists • FOPs are owned by households and are given to firms. Firms pay for them. • Households pay money to get goods and services produced by firms. • The income spent by households on firm’s output is known as Consumption Expenditure (C). A simple flow of output, expenditure and income.

  6. If all income is spent on C, then, National Income = National expenditure = National output

  7. The Open Circular flow of Income in an Economy • Government, Foreign trade exists. • Money can leak out from the circular flow in the form of: • Taxes (T) to the Govt. • Savings (S) • Imports (M) • Money flowing out is known as leakages or withdrawals from the circular flow of income because they do no represent payments made for goods and services produced in our economy.

  8. Therefore…. National income = Taxes+Savings+Imports+Consumption Y = T + S + M + C

  9. The Open Circular flow of Income in an Economy….. • Money can come into the circular flow in forms of: • Investment (I) • Government expenditure (G) • Exports (X) • Money flowing in is known as injections into the circular flow of income because they represent payments made for goods and services produced in our economy.

  10. Conclusion of Circular flow of income • Outputs and incomes are generated due to spending of consumers, firms, Govt and foreign firms. • If nothing was every bought, nothing would be produced, no FOPs will be hired, and no income would be earned. • One person’s expenditure is another’s person’s income.

  11. Aggregate Demand • AD is the total amount spent in an economy on its output over a given period of time. AD = C + I + G + X

  12. An Economy in EQM • AD = Total Output • As a result, prices and employment should be stable. • If output > demand, some will remain unsold. This will make firms produce less next time causing some FoPs to be unemployed and incomes will fall. • The state is Disequilibrium will occur. • If demand > output, more will be produced and more Fops will be used. Output, Employment and Incomes will increase.

  13. Flows of money in and out, that is injections and withdrawals, must be equal. • In an EQM, I+G+X = T+S+M • Therefore, C+I+G+X = T+S+M+C AD = National income If the above are not equal, the amount of income in the economy will change.

  14. Injection Withdrawals Example • Example on page 282

  15. Booms & Recession • Economic growth happens when real output (the total amount of g/s) produced are increased over time.

  16. The Trade cycle shows the ups and down in the national income. • Ups are known as Boom, and downs are known as Recessions or Slumps. • Recession for a long period of time is known as Depression • In Boom, real output and national income grow faster than normal. • In Recession, real output and national income fall faster than normal (negative economic growth)

  17. Characteristics of Boom • High level of spending • High level of investment in capital goods • High level of output • AD exceeds national output and firms try to increase output by employing more FoP. • However, full employment might be achieved where no more output can be produced. • This will cause prices to rise, known as, inflation, since firms can not meet demand. • Therefore, booms tend to be associated with high level of spending, low unemployment, rising prices and profits and a high level of output.

  18. Characteristics of Recession • Falling AD • Less investment • Lesser use of FoP • Unemployment • Further fall in spending since fall in incomes • National income falls • Prices may fall as firms try to increase the demand for their products. • Profits fall and many firms go out of business. • Falling prices makes X cheaper. • Firms producing X will start to increase output and employment. • Incomes begins to rise and so does spending • Economy is lifted out of recession. • Cycle goes on, powered by changes in demand in economy.

  19. The Multiplier Effect • A change in AD can cause a serious effect on the economy. • Once started, booms get bigger and Recession gets deeper. • This is due to the Multiplier effect, whereby a small change in spending can cause large changes in income, output and employment.

  20. Exercise 3

  21. What affects consumption and savings • The level of income • The Government • The availability of saving schemes • The rate of inflation • Personal factors • Interest rates

  22. What affects investment? • Business optimism • Interest rates • Technological advances • The Government

  23. What affects the demand for X? • Incomes in foreign countries • The value of currency • Interest rate

  24. Measuring National Income 1. The value of total output can be measured by how much people for them. • Total or national output should be the same as total or national expenditure

  25. Measuring National Income 2. Goods and services are produced by FoP which is a cost to producers but income to the owners of Fops. Thus, the value of national output should also be the same as the total value of incomes earned in a period of time, or national income.

  26. Measuring National Income National output = National expenditure = National Income

  27. From GDP to GNP • The total value of output produced by all domestic firms is Gross Domestic Product (GDP) • Income is also earned in form of interest on loans made abroad, rent from property aboard, profits from companies owned aboard and dividends on shares held in foreign companies. • These incomes from abroad must be added to get GDP. • Also, some country’s output is produced by foreigners and this means that incomes folow of the country to people and firms abroad. So this should be deducted from GDP.

  28. The difference between the flows of income coming into the country and those being paid aboard is Net property Income from Abroad. • GDP + NPIA = GNP • Gross National Product (GNP) is the total value of output from resources owned by people who live in a country, wherever these resources are located.

  29. From GDP to NNP • The amount spent on the repair or replacement of old, worn-out capital is known as depreciation. • It is also known as capital consumption which tells us that capital is being used up. • Net National Product is calculated by deducting the value of capital goods replaced, that is, depreciation from the total output of the economy, that is GNP. • NNP = GNP - depreciation

  30. Assignment • Exercise 5 on page 291

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