4.2.2 – Circular Flow of Income, AD/AS Analysis


    Income flows between Firms and Households
    • National Output is all the goods and services produced by a country
    • Households provide factors of production to produce goods = national income
    • Households spend income on goods & services to make=national expenditure
    • National income = national output = national expenditure

    Injections have a Multiplier Effect on the circular flow
    • an injection, usually an investment, is made into the circular flow.
    1. Multiplier effect occurs if the actual change in national income is greater than the initial injection
    2. Size of multiplier depends on rate at which money leaks out. Bigger withdrawals mean the quicker the money leaks
    o If lots of money spent is lost on tax, savings and imports the multiplier effect will be small
    The Multiplier Effect Leads to Larger Increase in AD
    • Injection into economy (government spending) causes shift to right
    • The money injected is multiplied
    • This occurs till all the money leaks out
    • For e.g. if government inject money in healthcare for wages it will increase consumption shifting curve right
    • Size of multiplier depends on size of leakages. Hard to measure size of multiplier as its always changing
    Average Propensity to Consume and Save
    • The average propensity formulas show the proportion of total national income spent or saved:

    Aggregate Demand – the total demand in an economy over a period of time
    • AD = Consumption + Investment + Government spending (Exports – Imports)
    • Total amount spent by households on goods and services and is the largest
    component of AD (65%)
    • Increase in consumption increases AD to the right
    • Income can be saved or consumed
    • Factors affecting consumption and savings are:
    o Income – as disposable income increases consumption will rise or could cause more savings
    o Interest rates – high interest rates reduce consumption and increase saving
    o Consumer confidence – if more confident about economy they spend more and save less
    o Wealth effect – rise is household wealth (e.g. house price) so are confident about own finances
    o Taxes – rise in direct tax (less disposable income) or indirect tax (VAT) reduce consumer spending
    o Unemployment – less consumption and more saving if unemployment rises. The fear of losing their job also
    causes more savings. Low unemployment rates increase consumption
    • Money spent by firms to produce goods and services like machinery, offices & better technology
    • Makes up 15% of AD and is done to make profit
    • Factors affecting investment:
    o Risk – level of risk affects amount of investment. High risk means less chance of investment
    o Government incentives and regulation – reduction in taxes (corporate tax) raise investment levels
    o Technical advances – firms invest in new technology to stay competitive and increase efficiency
    o Interest rates and access to credit – firms often borrow money to invest so high interest rates causes investment
    to be low as there’s less profit to be made
    o Business confidence and animal spirit – more confidence in making profit the more money invested. Animal
    spirits like emotion, gut feeling and intuition all are factors (Keynes believes)
    Government Spending
    • Money spent by government on public goods and services e.g. education, healthcare and defence
    • Transfers of money like benefits and pensions are excluded
    • This has a big influence of aggregate demand
    o If government spending is greater than revenue (money in) there’s a budget deficit= injection
    o If government spending is lower than revenue (money in) there’s a budget surplus= withdrawal
    • Governments use the fiscal policy to alter spending and taxation to influence AD
    o Low AD and growth may cause government to overspend (budget deficit)
    o High AD and growth may increase tax and spend less causing a (budget surplus)
    • In the long run the government will try to balance out any deficit or surplus
    o Long run deficit causes debt
    o Long run surplus causes harmful economic growth
    Imports and Exports
    • Exports are goods and services produced by one country and sold to another
    • Imports are goods and services brought into the country produced elsewhere
    • If imports exceed exports then net exports will be negative
    • Factors affecting Imports and Exports
    o The exchange rate – Strong Pound Imports Cheaper Exports Dearer
    – Weak Pound Imports Dearer Exports Cheaper
    o Change in state of world economy – the higher a countries real income the more it imports. So net exports fall
    as real income rises. The growth of other countries also affects imports
    o Degree of protectionism – in short run, tariffs and quotas increase net exports reducing imports.
    o Non-price factors – like higher quality goods made due to advancements in technology increasing exports


    AD curve slopes downwards so as price level decreases, more output is demanded

    • change in price level causes movement along the curve. If P1 fell to P2 then total
    demanded rises from Y1 to Y2
    • a rise in price level will cause output to fall as
    o less consumption occurs – more expensive
    o less exports made – less competitive
    o more imports made – cheaper abroad

    The AD Curve can Shift to the Right If:

    o reduction in tax so more disposable income
    o if government change fiscal policy so spends more (injection) into circular flow
    o a weak currency making exports cheaper and imports more
    • Labour’s derived demand so if AD shifts output increases, increasing number of jobs
    The AD Curve can Shift to the Left If:
    o A rise in interest rates reduces consumer spending and investment as
    borrowing money is expensive
    o A strong currency makes exports more expensive and imports cheaper
    • Shifts moves price level so as AD moves to AD1 the price level rises and if it moves to AD2 price level falls
    Rise in Demand might cause Accelerated Investment
    • The current rate of change of national income is used to determine if investment is needed.
    • If national income is growing rapidly then businesses invest heavily
    • Accelerated Effect= firms make accelerated investment in capital goods to increase output and make profit
    • Occurs during recovery or start of a boom
    • The Multiplier and Accelerator work together
    o During recovery – AD grows
    o Firms invest more – more AD growth
    o Increase in AD multiplied – making growth in national income more rapid
    o Leads to more accelerated investment
    • This process can also happen in reverse (in recession) likely to be a fall in demand and investment
    • This can lead to a constant cycle of output rising then falling

    • Multiplier = ____1____
    1 – MPC
    • The size of the MPC determines magnitude of
    Multiplier Effect

    Aggregate Supply

    • Aggregate supply is the total output produced in a economy at a
    given price level over a period of time
    • There are two types of Aggregate Supply:
    Short run aggregate supply – increase in price level increase output firms will supply
    • Changes in costs of production cause SRAS curve to shift
    o Change in wage rates (AD1 to AD3)
    o Change in exchange rates (AD1 to AD3)
    o Change in Productivity (AD1 to AD3)
    o Change in taxes (AD1 to AD3)
    o Supply side shocks like natural disaster and war (AD1 to AD2)

    Long run aggregate supply – rise in price level won’t increase output as
    economy is already running at full capacity

    • Changes in factors or production cause LRAS curve to shift:
    o Investment – advancing technology
    o Improved education and skills – more production
    o Improved healthcare – less health problems for workers
    o Demographic changes – skilled workers coming from abroad
    o Supply of new resources – increasing maximum output
    o Change in Government regulation changes – removal of red tape
    o Increased competition – inefficient firms close down and replaced
    with efficient firms
    o Promoting enterprise – incentives for starting business
    o Improvement in banking system – more money available for firms to
    borrow for investment
    o Reduction in supply – less oil for example reduces maximum possible

    The Keynesian LRAS curve is L-shaped

    • Keynesian economists argue that LRAS curve isn’t vertical
    1. At low levels of output, AS is completely elastic meaning
    there’s spare capacity
    ▪ Therefore, output can increase without a rise
    in price level
    2. When the curve slopes upwards it shows economy
    experiencing problems with supply which increase
    costs e.g. shortage of labour or raw materials
    Curve then becomes vertical when economy is at full capacity (Yf). AS is
    completely inelastic so can’t increase anymore

    Macroeconomic Equilibrium

    • Macroeconomic equilibrium is when aggregate demand = aggregate supply
    • A shift of either curve affects things in different ways :

    An increase in AD increases output in the Short run

    • The graph shows a SRAS curve and an AD curve
    • A shift from AD1 to AD2 forms a new equilibrium
    from a price level of P1 to P2
    • There’s an increase in output so more jobs
    • Rise in price level (inflation)
    • Decrease in AD has opposite effect reducing output and price level and increasing unemployment

    • The graph shows a LRAS curve with an AD curve
    • A shift from AD1 to AD2 keeps output the same but price level rises
    • To improve all 4 macroeconomic indicators an increase in LRAS is needed
    • A rise in price levels affects the balance of payments

    Amount of Spare Capacity Limits Multiplier Effect

    If supply is struggling to keep up with demand, the multiplier effect after
    an increase in AD will be quite small – economy won’t cope

    Shifts in AS Affect All Four Macroeconomic Indicators

    • An increase in SRAS leads to an increase in output.
    • There will be more jobs reducing unemployment
    • Price level will fall making economy more competitive with other countries (improve balance of payments)
    • Decrease in SRAS worsen the state of all four macroeconomic policies.
    • If LRAS increases you get similar results

    • if it shifts from LRAS1 to LRAS2 output is increased so price level falls with the
    balance of payments also improving
    • a shift will also cause all four macroeconomic objectives to improve or worsen
    Keynesian AS Curve Mean Changes in AS and AD have Different Effects

    • In a Keynesian LRAS curve an increase in AS can be slightly different
    o If AS increases from LRAS1 to LRAS2 there’s a change in macroeconomic equilibrium
    o If AD is at AD1, there’s no change in equilibrium
    • In a Keynesian LRAS curve an increase in AD can be slightly different
    o if AD increases from AD4 to AD5 then price level rises but output remains constant
    o if AD increases from AD1 to AD2 then output increases but price level is the same
    o if AD increases from AD3 to AD4 then output and price level increases





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