How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts

Notes · EconomicsUK · A-Levels

This chapter builds the core model of the macroeconomy. It develops the circular flow of income with its injections and withdrawals, the aggregate demand model and its components, aggregate supply in the short and long run in both the classical and Keynesian views, and the multiplier process that magnifies changes in spending - the tools used throughout the rest of macroeconomics.

4 sections~17 min reading time4 competenciesLevel Standard 2 · Advanced 2

T·101010 / 14

Exam profile

AO1 · Define the circular flow, injections and withdrawals, aggregate demand, aggregate supply and the multiplierAO2 · Calculate the multiplier and apply AD/AS analysis to shocks and policyAO3 · Analyse the effects of shifts in AD and AS on output and the price level using diagramsAO4 · Evaluate the classical and Keynesian views of AS and the size of the multiplier

Operators:defineexplainanalysecalculateevaluatedraw a diagram to show

basic level

AS-Level requires the circular flow, aggregate demand and its components, aggregate supply and simple AD/AS analysis.

higher level

The full A-Level adds the multiplier calculation, the classical-Keynesian debate on AS, and richer AD/AS analysis of shocks and policy.

Depth

Text

Contents · 4 sections

How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts

The circular flow of income, injections and withdrawals#

StandardAQA 7136 4.2.2DfE GCE Economics - the circular flow of income

The circular flow of income with injections and withdrawals

Fig. 1Households supply factors and spend; firms pay incomes and produce. Injections (I, G, X) add to the flow and withdrawals (S, T, M) leak from it; income rises when injections exceed withdrawals.

The circular flow of income is a model of how income, output and spending move around the economy. In its simplest form, households own the factors of production and supply them to firms, who pay factor incomes (wages, rent, interest, profit) in return; households then spend that income on the goods and services firms produce. Income (Y), output (O) and expenditure (E) are therefore equal and flow in a circle - one person's spending is another's income - which is why GDP can be measured three ways. This equality of income, output and expenditure is the foundation of national-income accounting.

The simple flow is modified by injections and withdrawals (leakages). Withdrawals are income that leaves the circular flow rather than being passed straight on as spending on domestic output: saving (S, income not spent), taxation (T, paid to the government) and imports (M, spending that goes abroad). Injections are spending that enters the flow from outside households' spending of their income: investment (I, firms' spending on capital), government spending (G) and exports (X, foreign spending on domestic output). The distinction is essential because injections and withdrawals determine whether the flow expands or contracts.

The economy is in equilibrium - national income is neither rising nor falling - when total planned injections equal total planned withdrawals: I + G + X = S + T + M. If injections exceed withdrawals, more is being added to the flow than is leaking out, so national income rises; if withdrawals exceed injections, income falls. This gives a first, intuitive account of what determines the equilibrium level of national output, which the aggregate demand and supply model and the Keynesian 45-degree diagram make precise.

The circular flow underlies the whole of macroeconomics. It shows how a change in any injection or withdrawal sets off a change in national income, and it is the natural home of the multiplier concept (developed in the last section): an initial injection circulates round the flow, becoming income and then spending again, so its total effect on national income exceeds the initial injection. Keeping the definitions of injections and withdrawals precise - and never confusing, say, saving (a withdrawal) with investment (an injection), even though they are linked - is the basis of clear macroeconomic analysis.

\text{Equilibrium: } I + G + X = S + T + M

Injections equal withdrawals

National income is in equilibrium when planned injections equal planned withdrawals. If injections exceed withdrawals, income rises; if withdrawals exceed injections, income falls.

Worked example

Is the economy in equilibrium?

In an economy, planned investment is 120 bn, government spending 200 bn and exports 150 bn pounds; planned saving is 140 bn, taxation 190 bn and imports 160 bn. Is national income rising, falling or stable?

Total injections
I + G + X = 120 + 200 + 150 = 470 bn pounds.
Total withdrawals
S + T + M = 140 + 190 + 160 = 490 bn pounds.
Compare
Withdrawals (490) exceed injections (470) by 20 bn: more is leaking from the flow than is being added, so national income is FALLING.

Result: Withdrawals exceed injections by 20 bn pounds, so the economy is not in equilibrium and national income is falling.

Typical mistakes

Muddling injections and withdrawals - saving, tax and imports are withdrawals; investment, government spending and exports are injections.
Confusing saving (a withdrawal by households) with investment (an injection by firms) - they are done by different agents for different reasons.

Active revision

Explain, using the circular flow of income, what happens to national income if injections exceed withdrawals.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Aggregate demand and its components#

StandardAQA 7136 4.2.2DfE GCE Economics - aggregate demand

An increase in aggregate demand (demand-pull)

Fig. 2A rise in a component of AD shifts the curve right from AD1 to AD2; equilibrium real output rises from Y1 to Y2 and the price level from P1 to P2 (demand-pull inflation) along the SRAS curve.

Aggregate demand (AD) is the total planned spending on an economy's goods and services at each price level in a given period. It has four components, captured by the identity AD = C + I + G + (X - M): consumption (C, household spending, the largest component), investment (I, firms' spending on capital goods), government spending (G, on public services and investment) and net exports (exports X minus imports M). Each component has its own determinants, and a change in any of them shifts the whole AD curve.

The AD curve is drawn sloping downwards, with the price level on the vertical axis and real output on the horizontal axis, but for reasons different from an individual demand curve. A lower price level raises real wealth and so consumption (the real-balance or wealth effect), tends to lower interest rates and so raise investment and consumption (the interest-rate effect), and makes domestic goods more competitive, raising net exports (the trade or international-competitiveness effect). These effects mean a lower price level is associated with higher real spending, giving the downward slope.

The determinants of each component are examinable in their own right. Consumption depends on disposable income (the main driver), wealth, consumer confidence and expectations, interest rates and the availability of credit. Investment depends on business confidence and expectations ('animal spirits'), interest rates and the cost of borrowing, the level of demand and spare capacity, corporate taxes and technological change. Government spending depends on fiscal policy and the state of the economy. Net exports depend on the exchange rate, relative inflation rates, the state of world and domestic income, and protectionism.

A change in any determinant shifts AD: a rise in consumer confidence or a fall in interest rates shifts AD to the right (an increase in aggregate demand), while austerity or a stronger currency (which cuts net exports) shifts it left. Tracing these shifts through the AD/AS model is the workhorse of macroeconomic analysis: identify which component changes and why, shift AD accordingly, and read off the effect on output and the price level from the AS curve, whose shape (examined next) determines how a change in AD splits between more output and higher prices.

AD = C + I + G + (X - M)

Aggregate demand

Total planned spending: consumption plus investment plus government spending plus net exports. A change in any component shifts the AD curve.

Worked example

Working out the change in aggregate demand

In an economy, consumption is 900, investment 200, government spending 350, exports 250 and imports 300 bn pounds. Calculate AD. Then investment falls by 60 bn; find the new AD and comment.

Initial AD
AD = C + I + G + (X - M) = 900 + 200 + 350 + (250 - 300) = 900 + 200 + 350 - 50 = 1,400 bn pounds.
After the fall in investment
Investment falls to 140, so AD = 900 + 140 + 350 - 50 = 1,340 bn pounds - a fall of 60 bn before any multiplier effect.
Comment
The direct fall in AD is 60 bn, but through the multiplier the eventual fall in national income will be larger; the AD curve shifts left, lowering output and the price level.

Result: AD falls from 1,400 to 1,340 bn pounds; the leftward shift of AD reduces output and the price level, magnified by the multiplier.

Typical mistakes

Explaining the AD curve's slope as if it were a single-market demand curve - it slopes down for the wealth, interest-rate and trade effects.
Forgetting that net exports (X - M) is a component - a rise in imports reduces AD.

Active revision

Using an AD/AS diagram, analyse the effect on output and the price level of a large rise in consumer confidence.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Aggregate supply: short run and long run, classical and Keynesian#

AdvancedAQA 7136 4.2.2DfE GCE Economics - aggregate supply

AD/AS with a vertical (classical) LRAS

Fig. 3In the classical view LRAS is vertical at full-employment output; SRAS slopes up. At the long-run equilibrium AD meets SRAS on the vertical LRAS - a rise in AD would then raise only the price level.

Aggregate supply (AS) is the total planned output of an economy's producers at each price level. The short-run aggregate supply curve (SRAS) slopes upwards: with the prices of inputs (especially wages) fixed in the short run, a higher price level raises firms' profit margins and encourages more output. The SRAS curve shifts when the costs of production change: a rise in wages, raw material or energy prices, or an indirect tax, shifts SRAS left (raising the price level - cost-push inflation), while a fall in costs or a rise in productivity shifts it right.

The long-run aggregate supply curve (LRAS) shows the economy's productive potential - the output it can sustain when all inputs, including wages, have fully adjusted. It is determined by the quantity and quality of the factors of production: the size and skills of the workforce, the capital stock, the state of technology, and the efficiency with which resources are used. LRAS shifts right - an increase in productive potential, which IS long-run economic growth - when these improve: more or better-educated workers, investment in capital, technological progress, or effective supply-side policy.

There are two views of the SHAPE of the LRAS curve, and the specification requires both. The classical (monetarist) view draws LRAS as vertical at the full-employment (or 'natural') level of output: in the long run the economy always returns to full capacity, so an increase in AD raises only the price level, not output. The Keynesian view draws LRAS as an inverted-L (or three-stage) shape: perfectly elastic (horizontal) when there is a deep recession with much spare capacity (an increase in AD raises output with no inflation), then upward-sloping as spare capacity is used up, then vertical at full capacity. The two views have very different policy implications.

The classical-Keynesian debate is a central evaluation theme. In the classical view, because LRAS is vertical, demand management (using policy to shift AD) cannot raise output in the long run - it only causes inflation - so policy should focus on supply-side measures to shift LRAS right. In the Keynesian view, when the economy is below full employment with spare capacity, a rise in AD can raise real output substantially with little inflation, so active demand management is justified in a recession. The truth is generally taken to depend on the state of the economy: the Keynesian analysis fits an economy with a large negative output gap, while the classical analysis fits an economy at or near full capacity, where further demand only pushes up prices. Being able to argue that the effect of a policy 'depends on how close the economy is to full employment' is a hallmark of a top answer.

Worked example

Cost-push versus demand-pull inflation

Explain, using AS and AD, the difference between the inflation caused by a rise in world oil prices and the inflation caused by a consumer-spending boom.

Oil price rise (cost-push)
Higher oil prices raise firms' costs, shifting SRAS LEFT. The price level rises but real output FALLS - cost-push inflation, associated with lower output (stagflation).
Spending boom (demand-pull)
A consumer boom shifts AD RIGHT. Along an upward SRAS the price level rises AND real output rises - demand-pull inflation, associated with a growing economy.
Contrast the output effect
The key difference is the direction of the output change: cost-push inflation comes WITH falling output, demand-pull inflation WITH rising output - which is why they call for different policy responses.

Result: Cost-push inflation (leftward SRAS) raises prices while cutting output; demand-pull inflation (rightward AD) raises prices while raising output.

Typical mistakes

Confusing a shift of SRAS (a change in costs) with a shift of LRAS (a change in productive potential).
Assuming an increase in AD always raises real output - on a vertical LRAS it raises only the price level.

Active revision

Using AD/AS diagrams, compare the effect of a rise in aggregate demand in the Keynesian and classical models of long-run aggregate supply.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

The multiplier and macroeconomic equilibrium#

AdvancedAQA 7136 4.2.2DfE GCE Economics - the multiplier

The Keynesian 45-degree diagram

Fig. 4Equilibrium national income is where planned aggregate expenditure (AE) equals output - where the AE line crosses the 45-degree line (Y = 4). A rise in the AE line raises equilibrium income by the multiplier times the shift.

The multiplier is the ratio of the eventual change in national income to the initial change in a component of aggregate demand that caused it. Its logic is the circular flow: an initial injection - say government spending on building a road - becomes income for the construction workers and firms involved; they spend part of that income, which becomes income for others, who spend part again, and so on in successive, diminishing rounds. The total rise in national income therefore exceeds the initial injection - the injection is 'multiplied'.

How much of each round's income is passed on depends on the marginal propensity to consume (MPC), the fraction of extra income that is spent on domestic output. What is not spent leaks out as the marginal propensities to save (MPS), to tax (MRT) and to import (MPM); these withdrawals sum with the MPC to 1. Because a fraction MPC is passed on each round, the rounds form a geometric series, and the simple multiplier is k = 1 / (1 - MPC), which equals 1 / MPS in a model with only saving. With all three leakages, k = 1 / (MPS + MRT + MPM) - the reciprocal of the marginal propensity to withdraw. The larger the MPC (the smaller the leakages), the larger the multiplier.

The multiplier is central to macroeconomic policy because it magnifies the effect of any change in AD - and works in both directions. A rise in investment, government spending or exports raises national income by a multiple of itself; equally, a fall in a component causes a magnified fall (a negative multiplier, the mechanism of a deepening recession). This is why fiscal stimulus can have a powerful effect, and why the SIZE of the multiplier is so contested: a larger multiplier makes demand management more potent. The Keynesian 45-degree diagram shows the equilibrium level of national income where planned aggregate expenditure equals output (the AE line crosses the 45-degree line), and a shift in the AE line changes equilibrium income by the multiplier times the shift.

The size and effect of the multiplier are matters for evaluation, not fixed facts. The multiplier is larger when leakages are small (a high MPC, low taxes and low import propensity) and when there is spare capacity so that extra demand raises output rather than prices - which returns to the AS analysis: on a vertical (classical) LRAS the real multiplier effect is nil, because extra demand only raises prices, whereas with spare capacity (a Keynesian horizontal AS) the full multiplier works on real output. The multiplier also takes time (the rounds are not instantaneous), and crowding out (government borrowing raising interest rates and reducing private investment) may offset it. So whether a fiscal injection delivers a large rise in real income 'depends on' the size of the leakages, the amount of spare capacity, and the extent of any crowding out.

k = \frac{1}{1 - MPC} = \frac{1}{MPS + MRT + MPM}

The multiplier

The multiplier is the reciprocal of the marginal propensity to withdraw. A higher MPC (smaller leakages) gives a larger multiplier. The change in income equals k times the initial change in spending.

MPC + MPS + MRT + MPM = 1

The marginal propensities sum to 1

Each extra pound of income is either spent on domestic output (MPC) or leaks out as saving, tax or imports; the propensities therefore sum to one.

The multiplier process through successive rounds

Fig. 5An initial injection of 100 with an MPC of 0.6 generates diminishing rounds of extra spending (100, 60, 36, ...) that sum to 100 / (1 - 0.6) = 250. Values are illustrative (£m).

Worked example

Calculating and applying the multiplier

In an economy the marginal propensity to save is 0.2, the marginal tax rate is 0.15 and the marginal propensity to import is 0.05. Government spending rises by 40 bn pounds. Find the multiplier and the eventual change in national income.

Add the leakages
The marginal propensity to withdraw = MPS + MRT + MPM = 0.2 + 0.15 + 0.05 = 0.4 (so MPC = 0.6).
Compute the multiplier
k = 1 / (MPS + MRT + MPM) = 1 / 0.4 = 2.5.
Apply to the injection
Change in national income = k x change in spending = 2.5 x 40 = 100 bn pounds - the 40 bn injection is multiplied to 100 bn, provided there is spare capacity.

Result: The multiplier is 2.5, so the 40 bn pound rise in government spending eventually raises national income by 100 bn pounds - if spare capacity allows the output to be produced.

Typical mistakes

Using the multiplier as k = 1 / MPC instead of k = 1 / (1 - MPC).
Applying the full multiplier to real output when the economy is at full capacity - on a vertical LRAS extra demand raises prices, not real income.

Active revision

An economy has an MPC of 0.75. Calculate the multiplier and the eventual effect on national income of a 20 bn pound rise in government investment, and explain two factors that could make the actual effect smaller.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts

4 sections~17 min reading time4 competenciesLevel Standard 2 · Advanced 2

Key points

Is the economy in equilibrium?

Key points

Working out the change in aggregate demand

Key points

Cost-push versus demand-pull inflation

Key points

Calculating and applying the multiplier

Sources

How the macroeconomy works: the circular flow of income, AD/AS analysis and related concepts

Key points

Is the economy in equilibrium?

Key points

Working out the change in aggregate demand

Key points

Cost-push versus demand-pull inflation

Key points

Calculating and applying the multiplier

Sources