Function Of The Level Of National Income example essay topic

What is 'macroeconomics'? You may have already studied microeconomics, which looks at supply, demand and prices for individual goods. Macroeconomics looks at the bigger picture and involves the study of the economy as a whole. National income Let us start by looking at a simple example - a'two sector' economy made up of households (consumers) and firms (producers) -and use this to develop the idea of national income. To start with we will ignore the impact of government policy and overseas sectors. Households ultimately own the factors of production, e. g., labour, materials and capital, and supply these factors to firms who use them to produce goods and services.

In return households earn rewards for supplying the firms with the factors of production e. g., wages and interest on capital. These rewards are in turn used to buy the goods that the firms have produced. This process is known as a circular flow- see Figure 1. Figure 1: Simple circular flow From Figure 1 we can see that there are three ways of measuring the amount of economic activity in the economy. These are: (a) National product / output = the flow counted atthi's point represents the amount received by firms for their total production. (b) National income = the flow counted at this point represents the total income received in return for factors of production. (c) National expenditure = the flow counted atthi's point represents the total expenditure by households on goods and services. If it is assumed that all income is spent, then whichever method is used the same measure of economic activity must be obtained.

Let's look ata numerical illustration. Illustration Assume there are two producers - a lumberjack and carpenter. The carpenter makes chairs each of which needs lb 5 worth of wood and which he sells for lb 20. Total annual sales are 10,000 chairs. The income and expenditure accounts for the lumberjack and carpenter are: Carpenter lb 000 Lumberjack lb 000 Purchases (wood) 50 Wages 40 Wages 10 Interest 20 Interest 5 Rent 50 Rent 20 Profit 40 Profit 15 Sales 200 Sales 50'National Product' = 200 This is the total value of the production (i. e., chairs) 'National Income' = 40 + 20 + 50 + 40 + 10 + 5 +20 + 15 = 200 This is the total received for factors of production i. e., wages, interest, rent and profit " National Expenditure' = 200 This is the total amount spent on production (i.e. chairs). We can see that the three measures of economic activity all give the same value.

Now we can start adding to this model to make it more realistic. This model will use the following definitions: Consumption (C) - consumption goods produced and sold to customers i. e., the chairs. Savings (S) - income that is not spent on consumption. Investment (I) - production of, or expenditure on, non-consumption goods (carried out by firms) including expenditure on increasing stocks of consumption goods. Injections - expenditure on domestic output not originating from consumers e. g., investment. Leakages - income not spent on consumption of domestic output e. g., savings.

Consumers will not spend all their income on goods and services. They will also have savings - income not spent on consumption. Similarly producers will not just spend on producing goods but will also carry out investment - expenditure on non-consumption goods. There are therefore injections into (investment) and leakages from (savings) the circular flow. These injections and leakages can now be added to the circular flow model (see Figure 2) Figure 2 Notes to Figure 2 In this model the income earned by households (Y) must be equal to expenditure on purchasing national product (E). Output of consumption goods by firms equals consumption expenditure by household's (C).

Note that households do not spend all their income - instead they save (S) - a leakage. Expenditure on non-consumption goods by firms is investment (I) - an injection. Income (Y) = Expenditure (E) Income (Y) = Consumption + Saving (C + S) Expenditure (E) = Consumption + Investment (C + I) Therefore, if a constant level of economic activity is to be maintained leakages will equal injections. In reality there are far more leakages and injections than just savings and investments, including government and overseas sectors, means that we will need to take into account additional leakages and injections. Leakages Injections Savings (S) Investment (I) Taxes (T) - paid to the governmentGovernmentspending (G) - on goods and services Imports (M) - amounts paid for goods and services originating in other countries Exports (X) - amounts received for goods and services sold in other countries As long as the various leakages are equal to the injections, income will equal expenditure and the economy will be in equilibrium. This is shown graphically in Figure 3.

Figure 3 Keynesian view of national income determination The level of national income in the economy is determined by level of aggregate demand (AD). Aggregate demand summarises the various sources of demand for the output of an economy. Aggregate demand (in a full economy) = C + I + G +X - Where: C = private sector consumption demand = private sector investment demand = government expenditure = export demand (i. e., demand from overseas for the national output) M = demand for imports Note that C, I and G may include demand for imported goods. However, imports are not part of the national output and are therefore deducted in calculating aggregate demand. In our earlier simple two-sector economy example with no government or overseas sectors, aggregate demand would have been C + I. As we saw earlier not all income is automatically used for consumption.

The Keynesian view is that consumption demand is a function of the level of national income, expressed by the consumption function: C = a + cY where: C = desired consumption (backed up by purchasing power) a = part of desired consumption which is independent of income level = 'marginal propensity to consume' - the proportion of each additional lb 1 of income which people wish to spend on consumption = national income Thus people's expenditure levels depend on their income. As income rises expenditure rises but not all of the extra income is spent. The consumption function may be plotted as shown in Figure 4. Figure 4: the consumption function As income rises so does desired consumption.

The marginal propensity to consume, c, is the slope of the line. Where there is a circular flow of funds expenditure equals income, giving the 45-degree line shown in Figure 3 (when the axes are on the same scale). This shows national output. Equilibrium within the economy occurs where aggregate demand is satisfied by national output. See Figure 5. Figure 5: National income determination Notes to Figure 5 A represents a point at which aggregate demand is not satisfied by national output.

Producers will increase output to meet demand and equilibrium at point Y will be reached. B represents a point at which aggregate demand is below national output so producers will have excess stocks so they will cut production and equilibrium at point Y will be reached. The idea of the economy reaching an equilibrium point is vital to the two main schools of thought regarding macroeconomics which students are expected to understand for the paper 4 examination- monetarist and Keynesian. The Monetarist view is that there is only one true equilibrium point for the economy and that this will be at full employment. Equilibrium will occur when supply equals demand in all markets. For labour this means that anyone who wants a job can have one.

Monetarists believe that the economy will automatically gravitate towards this equilibrium unless this is prevented by market imperfections. Thus, the role of government is to " free up' the economy by removing these imperfections. Once this is done the role of government becomes minimal. The market imperfections that need to be overcome include: (a) Inflation, because it distorts the price mechanism; (b) Government spending and taxation - ideally government spending will equal taxation so that government injections and leakages have no net effect; (c) Price fixing and minimum wages that distort the market for goods and services; (d) Regulation of markets; (e) Abuses of monopoly power. Keynesian theory is that the economy can be in equilibrium at many different times - not necessarily at just full employment.

Under this view governments can act to move the economy to a'better' equilibrium. Keynes argued that the equilibrium position is determined by the total demand for a country's goods and services ('aggregate demand') and thus the role of government was to manipulate aggregate demand to achieve policy aims. Various governments have followed one or other of the approaches over the years. Obviously you will not be required to discuss the economic history of the UK or any other country in the examination you will be expected to be able to discuss these theories in the examination and reference to real life examples is sometimes helpful to illustrate your answer. Macroeconomic objectives Since World War Two governments have adopted four central objectives for their macroeconomic policy. These are: Achieving economic growth - increasing supply and demand in the economy as a whole; Price stability - ensuring that general price levels do not increase because of inflation; Full employment - ensuring that everyone has a job if's / he wants one; Balanced balance of payments - managing relationships and trade with other countries.

Not all governments place the same emphasis on each of the four objectives but they feature in varying degrees of importance in all economic policies. For the remainder of this article we will look at why these areas are so important and briefly review the problems faced by governments in formulating their macroeconomic policy. Most governments aim to achieve economic growth. Growth should result in an increase in the goods and services being produced which in turn allows people to earn more. Economic growth should allow more people to find work and, in the right circumstances, lead to an improved standard of living. There is also the potential for an improved balance of trade as increased production is available for export and the level of demand for imported goods decreases.

However, growth can bring with it problems and challenges. A country needs to achieve economic growth per head of population rather than just in total terms. If, for example, a country's economy is growing by 5% per annum but the population is growing by 6% then the per capita economic wealth of the country is actually declining. This is a particular problem in developing countries where population growth rates remain high. Governments also need to take into consideration the type of growth being achieved and the impact this may behaving on the country and its population. The growth achieved at the cost of high levels of pollution or through the exploitation of the poor will be bad for the country in the longer term.

Government needs to consider the distribution of the gains from economic growth among the population. The gap between rich and poor will widen if gains are not shared out fairly and the government will need to decide to what extent and how to manage this process. Inflation In basic terms inflation occurs when there is excess demand which forces up prices and factor prices. Most governments want stable prices and low inflation.

In the UK the fight against inflation has been a mainstay of government policy for many years. One of the main reasons given for this is that inflation causes uncertainty as to future values and therefore stifles investment and prevents growth. Certain elements of society will be badly effected by high levels of inflation because not all incomes rise in line with it -those on fixed incomes suffer the most. High levels of inflation discourage saving because of the declining value of the money saved.

In extreme cases the function of money may break down resulting in civil unrest, as happened in Germany in the 1920's, or even war. In addition Monetarists consider that inflation distorts the working of the price mechanism and is thus a market imperfection preventing the economy reaching full employment equilibrium. So governments will be aiming to achieve economic growth while at the same time controlling inflation at an acceptable level. However, there are other elements to the macroeconomic balancing act which need to be taken.