National Income Equilibrium and the Effects of Interest Rate Changes (1997 Q9)

(A) What do you understand by equilibrium in the circular flow of income? (10)
v Part A requires a detailed answer with clear definitions and relevant diagrams to secure the marks.

v Don't draw the full-scale circular flow of income and spending diagram! This takes up far too much time for relatively
few marks. Define your terms and move straight to the analysis.

Define national income: National Income measures the value of the flow of output produced within the economy over a
period of time. GDP measures the value of output produced within the domestic boundaries of the UK. It includes the
output of foreign owned firms that are located in the UK. Gross National Product (GNP) measures the final value of output
or expenditure by UK owned factors of production whether they are located in the UK or overseas. GDP is only concerned
with incomes generated within the country.

Define national income equilibrium: Equilibrium national income is where the aggregate demand curve intersects
with the 45 degree line giving a position where planned expenditure = planned national output. At this point aggregate
demand = aggregate supply. Equilibrium also occurs when planned injections of aggregate demand equal planned
withdrawals from the circular flow of income.

Diagrammatic analysis of national income equilibrium: Variety of approaches possible here - examiners will give
credit for each of them if correctly applied.

Keynesian 45 degree line analysis: Intersection of aggregate demand schedule with the 45 degree line

45degrees 45degrees
E C+I+G+(X-M)1 E Ariseinthempc C1+I+G+(X-M)
C+I+G+(X-M)0
C0+I+G+(X-M)
Increasein
investment

Y0 Y1 Y0 Y1
NationalIncome NationalIncome
Equilibrium achieved when aggregate demand (C+I+G+X-M) equals planned output. At this level of income and output
there are no unplanned inventory changes. Analysis might explain why a level of national income other than Y0 creates a
macro economic dis-equilibrium. Changes in Ye caused either by a shift of the AD curve or by a change in the graident -
both shown above.

Injections and Withdrawal approach to showing equilibrium.

Equilibrium occurs when planned injections (I+G+X) equals planned withdrawals (S+T+M).

Injections of demand into the circular flow of income and spending are assumed to be exogenous (independent) of the
level of national income (although this is unlikely to be the case). The three withdrawals of income and spending in an
open economy with a Government sector are assumed to be endogenous. The demand for imports; the rate of taxation and
the level of saving are influenced by the level of national income.
 S+T+M
Injections,
Withdrawals
I+G+X
S+T

I+G
S

Ye
National income

Answers to part (A) might also use a numerical approach to supplement the diagrams. This may depend on how much time
you have available. A good numerical example helps support the injections and withdrawals diagram above.

Consider an open economy with a government sector with the following national income relationships

Consumption (C) = £500m + 0.75Y

Taxation (T) = 0.2Y
Saving (S) = -£500m + 0.05Y
Imports (M) = 0.25Y
Investment demand (I) = £250m
Export demand (X) = £250m
Government spending (G) = £300m

Ye when planned injections = planned withdrawals

i.e. when I+G+X = S+M+T
thus
J (injections) = 800m
W (withdrawals) = -£500m + 0.5Y
Thus 0.5Y = £1300m
Therefore Ye = £2600m

Assumes that the full-capacity level of national income is above £2600m - so that this level of national output and income
can be reached in the current time period.

(B) How might a change in the rate of interest affect the level of national income? (10)
This answer must focus on a range of economic variables. Changes in interest rates affect the economy in many different
ways - the transmission mechanism is quite complex and there are uncertain time lags between a change in interest rates
and their effect on aggregate demand and the overall level of economic activity.

Start with clear definition of interest rate - are we discussing money or real interest rates?

v Interest rates measure the rate of return on savings and the cost of borrowed money
v There is no unique rate of interest in the economy- but they all tend to move in the same direction
v The real rate of interest is the money rate of interest adjusted for inflation

Consider the effects of a change in interest rates - could be upwards (deflationary monetary policy) or downwards
(inflationary monetary policy). Focus on the impact on aggregate demand and all of its components - in particular
consumption, planned investment and the exchange rate and exports and imports. Then show how this feeds into a
changed equilibrium level of national income.

Housing market & house prices (wealth effects)

High interest rates increase the cost of mortgages and reduce the demand for most types of housing. A fall in interest rates
should stimulate higher demand and prices. This should increase consumption associated with house-buying and the rise in
prices will increase total housing wealth and make consumers more confident about their personal finances.
Effective disposable incomes of mortgage payers
If interest rates fall, the income of home-owners who have variable-rate mortgages with their building society or bank will
increase – leading to an rise in their purchasing power.

Credit demand
Low interest rates encourage people to spend using credit and should boost demand for "big ticket" consumer durables and
high street spending generally.

The factors mentioned above are likely to cause a change in the consumption function - a diagram should be used by way
of illustration. The diagram below shows a rise in the marginal propensity to consumer causing a change in the
marginal propensity to save.

Consumption
(C=Yd)
and
Sav ing C=a+c1Yd
C=a+cYd

a S=-a+(1-c)Yd
S=-a+(1-c1)Yd

Disposable Income
Y
-a

Investment & Stockbuilding

Firms take interest rates into account when deciding whether or not they go ahead with new capital investment spending .
A fall in interest rates should help to increase business confidence and raise the level of planned fixed investment. This
causes a movement down the marginal efficiency of investment schedule.

Rate
of
Interest

R1

M EI1
M EI
I I1 Investment

Sterling Exchange Rates

Lower interest rates might cause a depreciation of the exchange and boost demand for domestic producers who sell goods
and services in internationally traded markets. A rise in the growth of exports is an injection of aggregate demand into the
economy and increases the factor incomes of those in work.

A redistribution of income for savers & borrowers

When interest rates fall, there is a re-distribution of income away from lenders (who receive less) towards those with
variable rate loans. People with positive net savings also stand to lose out from big cuts in interest rates.
IMPACT ON NATIONAL INCOME EQUILIBRIUM OF LOWER INTEREST RATES

R ISE IN P L AN NED IN V E STM E NT F A L L IN T HE M P S

I,W I,W
S1+M+T

S2+M+T
S+T+M

I2+G+X

I+G+X
I1+G+X

Y1 Y2 Yfc Y Y1 Y2 Yfc Y

EVALUATION SCORES THE HIGHEST MARKS!

v Worth stressing that some industries are more affected by base rate changes than others (for example exporters) and
some regions of the economy are also more exposed (sensitive) to a change in the direction of interest rates. The
impact of interest rate movements is not uniform throughout the economy.

v The effects of interest rate changes will vary with time. In the short run the interest elasticity of demand both for
planned consumption and planned investment spending may be low. Eventually a sustained change in interest rates
should have quite a marked effect on the growth of aggregate demand, real output, income and employment.

v Because the UK is an open economy - the answer to part B must stress the exchange rate and balance of payments
effects to secure high marks.

Examiners will reward reference to current interest rate trends in the UK and some discussion as to why interest rates
have been changed. Clearly you could bring some wider knowledge and awareness of the Bank of England's policy
changes into this second part of the essay.

UK INTEREST RATE CHANGES SINCE 1994

Date New Level Change RPIX Inflation Sterling Index

8 April 99 5.25 -25 bp 2.4% 101.7

5 Feb 99 5.50 -50 bp 2.6% 100.3
8 Jan 99 6.00 -25 bp 2.5% 99.2
10 Dec 98 6.25 -50 bp 2.5% 99.6
05 Nov 98 6.75 -50 bp 2.5% 98.9
08 Oct 98 7.25 -25 bp 2.5% 100.6
04 Jun 98 7.5 +25 bp 2.8% 103.4
06 Nov 97 7.25 +25 bp 2.8% 102.4
07 Aug 97 7.00 +25 bp 2.8% 103.9
10 Jul 97 6.75 +25 bp 3.0% 104.1
06 Jun 97 6.50 +25 bp 2.7% 99.7
06 May 97 6.25 +25 bp 2.5% 99.7
Bank of England made operationally independent in May 1997
30 Oct 96 6.00 +25 bp 3.3% 89.8
06 Jun 96 5.75 -25 bp 2.8% 86.1
08 Mar 96 6.00 -25 bp 2.9% 83.7
18 Jan 96 6.25 -25 bp 2.8% 83.0
13 Dec 95 6.50 -25 bp 3.0% 83.0
02 Feb 95 6.75 +50 bp 2.5% 79.8
07 Dec 94 6.25 +50 bp 2.5% 80.3
12 Sep 94 5.75 +50 bp 2.0% 79.1

Geoff Riley