AQA A-Level Economics: How the Macroeconomy Works (7136)

This guide covers Section 3.2.2 How the macroeconomy works: the circular flow of income, aggregate demand/aggregate supply analysis and related concepts, part of Topic 2 (The National and International Economy) in AQA A-level Economics (7136). It is a distinct section from 3.2.1 The measurement of macroeconomic performance, already covered by the site’s existing guide – 3.2.1 covers the objectives of policy and how economic performance is measured, while 3.2.2 covers the circular flow and AD/AS models used to explain changes in that performance. These notes complement the site’s guide to The Measurement of Macroeconomic Performance.

Where this fits in 7136

Topic 2 is examined mainly on Paper 2, though questions may draw on microeconomic principles from Topic

1. The circular flow of income and AD/AS analysis are the models this section builds: once they are secure, much of the later Topic 2 content (economic growth, fiscal policy, monetary policy) can be explained as changes in injections and withdrawals or as shifts in one or more of the curves.

Syllabus coverage

AQA A-LEVEL ECONOMICS (7136) – 3.2.2 HOW THE MACROECONOMY WORKS: THE CIRCULAR FLOW OF INCOME, AGGREGATE DEMAND/AGGREGATE SUPPLY ANALYSIS AND RELATED CONCEPTS

• 3.2.2.1 The circular flow of income: what national income measures; nominal and real income; real national income as an indicator of economic performance; the circular flow, income = output = expenditure, and equilibrium and full employment income; injections and withdrawals, and the effect of changes in them on national income
• 3.2.2.2 Aggregate demand and aggregate supply analysis: movements along the AD and AS curves; the factors that shift AD and short-run AS, and those that affect long-run AS; underlying economic growth as a rightward shift in long-run AS; macroeconomic equilibrium; demand-side and supply-side shocks
• 3.2.2.3 The determinants of aggregate demand: what is meant by AD; the determinants of consumption, investment, government spending, exports and imports; the basic accelerator process; the determinants of savings; the difference between saving and investment
• 3.2.2.4 Aggregate demand and the level of economic activity: the role of AD; the multiplier process; the marginal propensity to consume (MPC) and its use to calculate the multiplier
• 3.2.2.5 Determinants of short-run aggregate supply: the price level and production costs, with changes in costs such as money wage rates, raw material prices, business taxation and productivity shifting the curve
• 3.2.2.6 Determinants of long-run aggregate supply: technology, productivity, attitudes, enterprise, factor mobility and economic incentives; the vertical long-run AS curve at the normal capacity level of output; the institutional structure of the economy; the Keynesian AS curve

How to approach it

Students should recognise that there are multiple macroeconomic models, be critically aware of their assumptions and limitations, and be prepared to propose, analyse and evaluate solutions to macroeconomic problems using this framework. The AD-AS diagram is the single most reusable tool in the whole qualification: almost every essay question in Topic 2 can be answered, at least in outline, by identifying which curve moves, in which direction, and what that implies for output, employment and prices.

Official syllabus

AQA A-level Economics (7136) specification, first teaching 2015 – aqa.org.uk.

The circular flow of income (3.2.2.1)

National income measures the value of the goods and services an economy produces in a period. Nominal income is measured at current prices; real income is adjusted for changes in the price level, so real national income is used as an indicator of economic performance (nominal income can rise simply because prices have risen). In the circular flow, households supply factor services to firms and receive income, which they spend on firms’ output, so income = output = expenditure.

Some income leaves the flow as withdrawals – saving (S), taxation (T) and spending on imports (M). Other spending enters it as injections – investment (I), government spending (G) and exports (X). National income is in equilibrium when planned injections equal planned withdrawals. If injections rise relative to withdrawals, national income rises; if withdrawals rise relative to injections, it falls. The equilibrium level need not be full employment income (the level at which the economy’s resources are fully employed) – it can settle below it.

AD/AS analysis (3.2.2.2)

A change in the price level is a movement along the AD and AS curves; a change in any other determinant shifts a curve. Macroeconomic equilibrium is where AD meets AS. A demand-side shock (for example, a collapse in business confidence, or a recession abroad cutting demand for exports) shifts AD; a supply-side shock (for example, a sharp rise in world oil prices) shifts SRAS. Underlying economic growth is shown as a rightward shift in LRAS. The same diagrams can illustrate changes in the price level, demand-deficient (cyclical) unemployment and economic growth.

The determinants of aggregate demand (3.2.2.3)

AD = C + I + G + (X - M): consumption, investment, government spending, and net exports. Each component has its own determinants – consumption responds to disposable income, interest rates, wealth and consumer confidence; investment responds to interest rates, business confidence and expected future demand; government spending is a policy choice; exports and imports respond to the exchange rate, relative inflation rates, and incomes at home and abroad. A change in any one component shifts the whole AD curve.

The accelerator. Investment depends on the rate of change of demand for output, not only its level. When demand grows faster, firms need more capital to meet it, so net investment rises by proportionately more; when demand growth merely slows, net investment can fall even though output is still rising. (No accelerator calculations are required.)

Saving. Saving is the part of disposable income not spent on consumption. It is influenced by the level of income, interest rates, wealth, the availability of credit, and confidence or expectations about the future (such as job security). Saving and investment are different things: saving is a withdrawal made mainly by households, investment is spending on capital goods made mainly by firms – an injection – and the two are planned by different people for different reasons.

The multiplier and the MPC (3.2.2.4)

An initial change in expenditure has a larger final effect on national income, because one person’s spending becomes another’s income, part of which is spent again. The marginal propensity to consume (MPC) is the proportion of an extra pound of income that is spent and so passed on. The rest is withdrawn from the flow, so the larger the MPC, the less is lost at each round and the larger the multiplier.

multiplier = 1 / (1 - MPC)

MPC = 0.8:  multiplier = 1 / 0.2 = 5
An extra £10bn of investment: £10bn + £8bn + £6.4bn + ...
            = £10bn x 5 = £50bn rise in national income

AQA requires the multiplier to be calculated from the MPC only; calculations from the marginal propensities to withdraw are not expected.

Short-run aggregate supply (3.2.2.5)

The main determinants of short-run aggregate supply (SRAS) are the price level and production costs. A change in costs – money wage rates, raw material prices, business taxation, or productivity (higher productivity lowers unit costs) – shifts SRAS. Cost changes such as a rise in money wages or raw material prices can shift SRAS without any change in the economy’s underlying capacity, whereas a lasting rise in productivity also shifts LRAS (3.2.2.6).

Long-run aggregate supply (3.2.2.6)

Long-run aggregate supply (LRAS) is drawn vertical at the economy’s normal capacity level of output, reflecting the idea that in the long run output is determined by the quantity and quality of factors of production, not by the price level. Its fundamental determinants are technology, productivity, attitudes, enterprise, factor mobility and economic incentives. The institutional structure of the economy matters too – for example, a banking system that channels saving into investment funds for businesses supports capacity growth. LRAS shifts rightward only through genuine increases in productive capacity.

The Keynesian AS curve takes a different shape. It is horizontal at low levels of output, where there is substantial spare capacity and unemployment, so a rise in AD increases output without raising the price level; it slopes upwards as the economy nears full capacity and bottlenecks push costs up; and it becomes vertical at full-capacity output, where a further rise in AD raises only the price level. On this view the economy can stay in equilibrium well below full employment unless AD rises – unlike the vertical LRAS model, in which a change in AD affects only the price level in the long run.

Worked example: reading an AD-AS shift

The routine below is an original model written for this resource, not a reproduction of any official past paper or mark scheme.

Scenario: A fall in business confidence reduces planned investment.

Step 1 - identify which curve moves:
AD shifts left (investment is a component of AD, not AS).

Step 2 - state the immediate effect on output and prices:
Lower AD -> lower equilibrium output and lower price level in the
short run (on an upward-sloping SRAS curve; on the flat section of
a Keynesian AS curve, output falls with little change in prices).

Step 3 - state the effect on employment:
Lower output typically means lower employment, since fewer workers
are needed to produce it.

Step 4 - distinguish a short-run effect from a long-run one:
If LRAS is unaffected, this is a short-run demand-side problem --
the economy's long-run capacity is unchanged, only how much of it
is currently being used.

Step 4 is what distinguishes stronger answers: AQA’s Paper 2 examiner reports say separating short-run from long-run effects marks out ‘better students’ (June 2023) and ‘stronger responses’ (June 2025), while weaker answers describe only the short-run AD effect and never address whether the economy’s underlying capacity (LRAS) has changed at all.

Why the AD-AS model is treated as one of several competing models

Students should recognise that there are multiple macroeconomic models, be critically aware of their assumptions and limitations, and be prepared to propose, analyse and evaluate solutions to macroeconomic problems – the AD-AS framework is powerful but rests on simplifying assumptions (for example, treating the whole economy’s supply-side behaviour as summarisable in a single curve). The section itself contains two views of aggregate supply: the vertical LRAS curve, and the Keynesian AS curve with its spare-capacity range. Stronger answers say which they are using and why it matters – a rise in AD raises output on the Keynesian curve’s flat section but only prices on a vertical LRAS – rather than treating either model as a literal description of how the economy works.

Common mistakes

Treating aggregate demand and microeconomic market demand as identical concepts (AD sums across the whole economy, not one market). Forgetting that net trade is exports MINUS imports, so a rise in imports alone reduces AD. Confusing a rightward shift in SRAS (a fall in production costs) with a rightward shift in LRAS (a genuine capacity increase). Describing government spending changes without noting they are a policy choice, not a market-determined variable. Treating saving and investment as the same thing. Calculating the multiplier as 1 / MPC instead of 1 / (1 - MPC).

Quick revision checklist

• Explain the circular flow, income = output = expenditure, and the effect of changes in injections and withdrawals on national income; distinguish nominal from real income.
• Name and explain the determinants of each AD component, the accelerator and the determinants of saving; distinguish saving from investment.
• Explain the multiplier and calculate it from the MPC.
• Distinguish the causes of SRAS shifts from the causes of LRAS shifts.
• Explain why LRAS is drawn vertical, what shifts it (including institutional structure), and how the Keynesian AS curve differs.
• Use an AD-AS diagram to trace the short-run and long-run effects of a stated economic event.
• Link a change in AD or AS back to Section 3.2.1’s measures of macroeconomic performance (inflation, output, employment).