The circular flow of income, aggregate demand and aggregate supply

Last time

Before we start: last time, in Measuring inflation, its causes and consequences, and deflation, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

The whole economy

Macroeconomics studies the whole economy: total output, the price level, employment. The circular flow shows how income moves round the economy; aggregate demand and aggregate supply show how output and prices are decided.

The circular flow

Households supply factors of production to firms and receive incomes; they spend the incomes on firms' goods and services. In a closed economy with no government, this flow could go round unchanged.

Injections and withdrawals

Withdrawals, or leakages, take money out of the flow: saving, taxation and imports. Injections add money: investment, government spending and exports. If injections exceed withdrawals, national income rises; if withdrawals exceed injections, it falls. Equilibrium is where they are equal.

Closed and open economies

A closed economy has no international trade. An open economy trades with others. Moving to an open economy adds exports as an injection and imports as a withdrawal. So the flow becomes more exposed to changes in world demand.

Aggregate demand

Aggregate demand is total planned spending on an economy's goods and services: AD equals C plus I plus G plus X minus M. The AD curve slopes down: a lower price level raises real wealth, lowers interest rates, and makes exports more competitive. AD shifts with changes in its components: confidence, interest rates, government spending, taxes, exchange rates and world income.

Aggregate supply

Short-run aggregate supply slopes upwards: firms supply more as prices rise, while costs are fixed in the short run. SRAS shifts with costs of production: wages, raw material prices, indirect taxes and the exchange rate. Long-run aggregate supply depends on productive capacity: the quantity and quality of resources and technology.

AD and AS

Macroeconomic equilibrium is where AD meets SRAS: here at a price level of 5 and real output of 5. An increase in AD, from AD to AD1, raises both real output and the price level, to 6 and 6.

When does rising AD become a problem?

When there is spare capacity, rising AD mainly raises output and employment, with little inflation. Near full capacity, firms cannot raise output much, so rising AD mainly raises prices: demand-pull inflation. So the effect depends on how close the economy is to its productive capacity.

The shape of AS and fiscal policy

If AS is flat, with spare capacity, fiscal expansion raises output with little inflation. If AS is steep, near capacity, fiscal expansion mainly raises prices, and contraction would be needed for price stability. So the AS shape affects how well fiscal policy can achieve price stability.

Mistakes that lose marks

Mistake one: confusing injections with withdrawals. Mistake two: labelling AD/AS axes price and quantity, instead of price level and real output. Mistake three: saying higher AD always causes inflation. The fix: correct labels and spare-capacity evaluation.

The full-marks tip

The full-marks tip: label AD/AS diagrams with price level and real output. Evaluate the effects of AD changes with spare capacity and the shape of AS.

On one card

So, on one card: the circular flow, AD and AS. Keep it for revision.