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Unit 1

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The 5-sector model

5-sector circular flow model

Savings, Taxation and Imports are Leakages.

Investment, Government expenditure, and Exports are Injections.

When Leakages > Injections there is a decline in economic activity. When Injections > Leakages there is an increase in economic activity.

Note that:

  • Households provide Firms with the Factors of Production (e.g Labour) and Consumption
  • Firms provide Households with Goods and Services and Income
  • In order to achieve equibrilium, Savings, Taxation and Imports must equal Investment, Government Expenditure, and Exports. This is represented by the equation…

I + G + X = S + T + M

Because the 5-sector model featurs 5 sectors (Households, Firms, Financial, Government, Overseas) and it is circular (look at those arrows!) it is known as a macroeconomic model

Define macroeconomic the study of the economy as a whole.

We use money instead of bartering goods because it means more links between sectors.

The business cycle

The business cycle is the cyclical fluctuations (i.e booms and recessions) in the general level of economic activity

Business cycle

Contraction v Expansion

  1. An expansion occurs when there is an increase in economic activity.
  2. A contraction occurs when there is a decrease in economic activity.
  3. A recession occurs when there has been a significant contraction in economic activity (typically a significant decline in GDP over two quarters).
  4. A depression occurs when there is a more severe economic decline compared to a recession, characterised by years of GDP failing and increasing unemployment.

Fluctuations in the Business Cycle occur because of either too little spending, or too much spending.

Recessions and Depressions - too little spending

Recessions and depressions are characterised by a lack of spending. Key features include:

  • Income and production at its lowest level
  • Unemployment at its highest level
  • Limited wage growth
  • Consumer demand at its lowest level
  • Business sales and profit at its lowest levels
  • Business expansion/investment at its lowest levels
  • Low inflation rates and interest rates

Boom - too much spending

Booms are characterised by too much spending. Key features include:

  • Income and production at its highest level
  • Unemployment at its lowest level
  • High wage growth
  • Business investment and expansion
  • Increased demand = increased prices
  • High interest rates and inflation rates

The role of government

Our economy is a mixed economy - an economic system in which individuals and businesses make their own decisions but with a degree of government involvement. The government controls different aspects of fiscal policy and monetary policy.

Definition of Fiscal Policy Fiscal policy is the use of government revenue collection and expenditure to influence a country's economy.[^1]
Definition of Monetary Policy Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.[^2]

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