Income and Expenditure

This chapter will consider the macroeconomic mechanisms that govern the flows of income and expenditure within an economy.

It will first look at the key concept of the circular flow of income, which introduces many of the factors the govern national income in an economy. This then leads to discussion of the determinants of national income, also called aggregate demand. The Keynesian calculation for aggregate demand, C+I+G+(X-M), is presented and explained. This is accompanied by an explanation of the Keynesian Cross diagram which shows how aggregate demand and national output achieve equilibrium and form real GDP.

To support the understanding of the macroeconomic models the underlying assumptions are explored.  This includes critique of the theories relating to rational decision making from consumers regarding their incomes. The random-walk hypothesis of income is compared to the permanent income hypothesis in order to identify the differences in assumptions of consumer behaviour. The way that consumers view income is a key determinant of their spending habits - so a rational view such as the permanent-income hypothesis assumes that consumers will spend based on their anticipation of future income. This leads to spending being distributed across the lifetime and future expectations to be a strong influence. Random walk alternately posits that consumer spending is unpredictable.

As further information to support the role of consumers as part of the GDP equation the concept of equilibrium between demand  and supply is also demonstrated. This uses both the classic supply and demand diagram as well as an explanation on price elasticity of demand - which determines the slope of the demand curve.
Price elasticity shows how a good or service can vary on a spectrum between inelastic and elastic in terms of the responsiveness of demand to changes in price. So, an inelastic good can see its price change by a large amount and demand only alter by a smaller amount. The opposite applies to a good on the elastic side of the spectrum - small price changes cause large demand change.

As an extension of the discussion of market mechanisms for demand, the IS/LM graph is also included. This model explains the dynamics of supply and demand in both the goods markets and money markets.  The derivation for both the IS and LM curves are explained, with the factors that determine each being presented.
This model is used to identify the equilibrium between aggregate output / national income and the interest rate.

Overall, this chapter introduces the core concepts needed to understand the fundamental movements of value within an economy. It shows the way that value travels in the circular flow, the determinants of national income, the basic way that consumers react to and use this income and then the mechanisms for how the income can alter in response to other factors.


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