National Income and AD/AS Analysis: Economics 9708 (Cambridge International AS & A Level)

Economists modelling the small open economy of Kelmara use the circular flow of income to trace how spending, output and income circulate between households, firms, the government and the rest of the world.

Which of the following is a withdrawal (leakage) from Kelmara's circular flow of income, rather than an injection into it?

Vantoria's national statistics office has collected the following data for last year (all figures in $ billion).

(a) Using the expenditure method, calculate Vantoria's Gross Domestic Product (GDP) at market prices. [3]

(b) GDP at market prices includes taxes on products (such as sales taxes) and excludes subsidies on products, whereas GDP at basic prices removes this effect to show what producers themselves actually receive. Calculate Vantoria's GDP at basic prices. [2]

(c) Calculate Vantoria's Gross National Income (GNI). [2]

(d) Calculate Vantoria's Net National Income (NNI). [2]

Bellamar is a small open economy. Economists have estimated the following annual flows for Bellamar (all figures in $ billion).

(a) State which three of these flows are injections into Bellamar's circular flow of income, and which three are withdrawals from it. [2]

(b) Calculate Bellamar's total injections and total withdrawals, and state whether Bellamar's national income is likely to be expanding, contracting, or staying the same. [3]

(c) Explain why a circular flow of income diagram for Bellamar must include a "rest of the world" sector, whereas a circular flow diagram for a closed economy would not need one. [3]

Halvern's central bank unexpectedly cuts its base interest rate from 6% to 3%, making it significantly cheaper for households and firms to borrow.

(a) State the equation for Aggregate Demand (AD) in terms of its four components, and identify which component(s) of AD are most directly affected by a cut in the interest rate. [3]

(b) Explain why this interest-rate cut causes a shift of Halvern's AD curve, rather than a movement along it, and state the direction of the shift. [3]

(c) Halvern's short-run aggregate supply (SRAS) curve is upward sloping. Describe, using the AD/AS model, the effect of the shift you identified in (b) on Halvern's equilibrium price level and level of real output in the short run. [3]

Meridia's government announces a large, permanent increase in spending on public infrastructure - new roads, ports and power stations - financed largely through additional government borrowing. This is a rise in the G component of Aggregate Demand (AD).

(a) Using the AD/AS model, explain how this rise in government spending is likely to affect Meridia's AD curve, and state the general effect of a rightward shift in AD on the equilibrium price level and equilibrium real output, holding the aggregate supply curve constant. [3]

(b) In one commonly used model, the long-run aggregate supply (LRAS) curve has three sections: a section that is highly elastic (close to horizontal), where the economy has considerable spare capacity; a section that slopes upward, as spare capacity is gradually used up; and a section that is vertical, once the economy reaches full employment and its maximum productive capacity. Discuss the extent to which the effect of the rise in government spending described in (a) on Meridia's price level and real output would differ, depending on which of these three sections currently represents the state of Meridia's economy. [7]

A country's national statisticians measure Gross Domestic Product (GDP) using the output method, which adds together the contribution made by every firm in the economy, from raw-material producers through to final retailers.

To avoid counting the same output more than once as it passes through several stages of production, which of the following must the statisticians do?

Firms in the small country of Oskana produce wooden furniture through a single production chain: a forestry company sells timber to a furniture manufacturer, who sells finished tables to a retailer, who sells the tables to final consumers. There is no other economic activity in Oskana this year.

(a) Explain what is meant by "value added", and state why the output method sums value added rather than each firm's gross sales revenue. [3]

(b) Calculate the value added created at each of the three stages, and hence calculate Oskana's GDP this year by the output method. [4]

(c) Calculate the total gross sales revenue summed across all three stages, and explain why this figure would overstate Oskana's true GDP if it were used instead of the value-added total from part (b). [2]

Consider a simple two-sector circular flow of income model for a closed economy, containing only households and firms and no government. Households own all the factors of production (labour, land, capital and enterprise), and firms produce all goods and services.

(a) State what is meant by a "real flow" and a "money flow" in this circular flow of income model. [2]

(b) In the market for factors of production, state the direction in which factors of production flow between households and firms, and the direction in which factor income flows in return. [2]

(c) In the market for goods and services, identify which of the two flows (goods and services, or expenditure) is the real flow and which is the money flow, and explain why these two flows always move in opposite directions around the circular flow diagram. [3]

A sudden, sustained rise in the world price of imported crude oil sharply raises production costs for firms across the economy of Doravia, since oil is used extensively in transport, manufacturing and energy generation. Doravia's aggregate demand (AD) is unaffected by this event.

(a) Explain how this rise in the cost of a key imported input is likely to affect Doravia's short-run aggregate supply (SRAS) curve. [3]

(b) Using the AD/AS model, explain the effect of the shift you identified in (a) on Doravia's equilibrium price level and equilibrium real output in the short run. [3]

(c) Discuss the extent to which this negative supply-side shock creates a more difficult trade-off for Doravia than a fall in aggregate demand of similar size, given its combined effects on the price level, real output and employment. [6]

Economy Y has a Gross Domestic Product (GDP) of $500 billion this year. Economy Y's Gross National Income (GNI) for the same year is calculated to be $480 billion, which is lower than its GDP.

Which of the following correctly explains why Economy Y's GNI is lower than its GDP?