AQA A-level Economics: Circular flow, AD and AS analysis and determinants of aggregate demand (7136) – Revision Notes

These notes cover three sub-sections of the AQA A-level Economics (7136) specification, version 1.3: the circular flow of income, aggregate demand and aggregate supply analysis, and the determinants of aggregate demand. The PDF numbers them 4.2.2.1 to 4.2.2.3; the AQA website and the site map call them 3.2.2.1 to 3.2.2.3. They stand alone, so you can revise from this page, the practice questions and, for a fuller treatment of the same diagrams, the AQA aggregate demand and supply study guide. Every country and figure is invented and illustrative. Course pages: AQA A-level Economics hub, checklist and free diagnostics.

The size of the multiplier, the shape of the short-run and long-run aggregate supply curves in detail, and the link between AD and the level of activity belong to neighbouring sub-sections and are not taught here.

1. National income, nominal and real

National income measures the value of the output a country produces in a period. The same total can be found as income earned, output produced or expenditure made. You need the idea, not the detail of how the accounts are built.

Term	Meaning
Nominal income	Valued at the prices ruling when the output is produced
Real income	Nominal income adjusted for price changes, so it tracks the volume of output
Price index (deflator)	Average price level, with the base year set at 100

Method: real income = nominal income / (index / 100).

Worked example (Country F, illustrative). Year 1: nominal income 2,400, index 100. Year 2: nominal income 2,725, index 109.

• Real income in year 2 = 2,725 / 1.09 = 2,500.
• Nominal growth = 2,725 / 2,400 = 1.1354, so 13.5%.
• Real growth = 2,500 / 2,400 = 1.0417, so 4.2%. Most of the nominal rise reflects higher prices.
• If the population rises from 15.0 million to 15.3 million, real income per head moves from 2,400 / 15.0 = 160.0 to 2,500 / 15.3 = 163.4. That is a rise of 2.1%.

Real national income is the usual indicator of economic performance because it shows whether more is being produced. Limits: it ignores how income is shared, unpaid work, the black economy, quality changes, working hours and environmental damage. Per head figures matter when the population is changing.

2. The circular flow of income

Households provide labour and other factors to firms and are paid for them. They spend that income on what firms produce. So income = output = expenditure, and the flow goes round.

	Items	Effect
Withdrawals (W)	Saving (S), taxation (T), import spending (M)	Income leaves the flow
Injections (J)	Investment (I), government spending (G), exports (X)	Spending enters the flow

• Equilibrium national income: planned injections equal planned withdrawals, so the flow is steady and income is not changing.
• Full employment income: income when every available resource is in use. Equilibrium can settle below it (spare capacity). Spending that pushes demand beyond it cannot raise real output further, so it puts pressure on prices.
• J = W is the condition. It is S + T + M = I + G + X. It does not say S = I.

Worked example (Country F). Injections: I 85, G 95, X 110, so J = 290. Withdrawals at income Y: S = 0.06Y, T = 0.20Y, M = 0.14Y, so W = 0.40Y.

Income Y	S	T	M	W	Compare with J = 290
600	36	120	84	240	W < J: income rises
725	43.5	145	101.5	290	W = J: equilibrium
850	51	170	119	340	W > J: income falls

Effect of changes (same country):

• Investment rises by 20, so J = 310. Equilibrium: 0.40Y = 310, so Y = 775. Income rises by 50.
• Instead, the saving rate rises from 0.06 to 0.10, so W = 0.44Y. With J = 290, Y = 290 / 0.44 = 659.1. Income falls by about 65.9.
• If full employment income is 780, equilibrium of 725 is 55 below it, which is 7.1% of 780. The investment rise closes most of that gap. Any rise taking J above 312 (which is 0.40 x 780) would push demand past capacity.

Chain: injection up, firms’ sales up, output and incomes up, households spend part again and withdraw part, until W has risen to equal the new J. A fall in an injection or rise in a withdrawal runs the other way.

3. AD and AS analysis

Axes: price level (vertical), real output or real GDP (horizontal). AD slopes down, short-run AS slopes up, long-run AS is vertical.

Movement or shift? If the price level changes, you move along the curves. If anything else changes, a curve shifts.

Curve	Shifts when	Examples
AD	C, I, G or (X - M) changes at each price level	Confidence falls, interest rates rise, a trading partner enters recession
Short-run AS	Production costs change	Wage rates, raw material prices, business taxes, productivity, energy costs
Long-run AS	Productive capacity changes	Technology, productivity of labour and capital, attitudes and enterprise, mobility of factors, incentives

Distinguish short from long run: a cost rise such as dearer fuel can shift short-run AS without altering capacity. Lasting changes in the quantity or quality of resources shift long-run AS.

Underlying economic growth is a rightward shift in long-run AS. Short-run growth from using spare capacity is a movement towards it.

Macroeconomic equilibrium is where AD meets AS: a price level and a level of real output.

Worked example (Country F, price index and real output in units).

Price level	AD	Short-run AS
90	1,050	870
100	1,000	910
110	950	950
120	900	990
130	850	1,030

AD: Y = 1,500 - 5P. Short-run AS: Y = 4P + 510. Equilibrium: 1,500 - 5P = 4P + 510, so 9P = 990, P = 110, Y = 950. Long-run AS at 1,000 means output is 50 below capacity, a gap of 5.0%. That gap is demand-deficient (cyclical) unemployment, because labour is idle for lack of spending.

• Demand-side shock: AD falls by 45 at each price. Y = 1,455 - 5P. New equilibrium: P = 105, Y = 930. Output falls 2.1%, prices fall 4.5%.
• Supply-side shock: short-run AS falls by 27 at each price. Y = 4P + 483. With the original AD, P = 113, Y = 935. Prices rise 2.7% and output falls 1.6%.
• Growth: long-run AS moves from 1,000 to 1,040, a rise of 4.0% in capacity.

Reading shocks: after a demand shock, price and output both rise or both fall; after a supply shock, one rises while the other falls.

Global events affect a domestic economy through exports and imports (AD), imported raw materials and energy (short-run AS), exchange rates, confidence, and flows of finance and technology. A slump abroad shifts AD left; a world commodity price rise shifts short-run AS left.

4. The determinants of aggregate demand

AD is the spending plans of households, firms, government and overseas buyers for a country’s output, at each price level: AD = C + I + G + (X - M).

Part of AD	What moves it
Consumption (C)	Take-home pay after tax and benefits, borrowing costs, household wealth, mood about the future, ease of getting loans
Investment (I)	Borrowing costs, expected profit and firms’ confidence, growth of demand (accelerator), profit taxes, bank lending, new technology
Government spending (G)	Policy choices, the size of the budget deficit, benefit payments that rise in a downturn, an ageing population
Exports (X)	Incomes abroad, the exchange rate, how prices and quality compare with rivals, tariffs and quotas
Imports (M)	Incomes at home, the exchange rate, how prices and quality compare with foreign goods, tariffs and quotas

Net exports in numbers (Country F): C 740, I 190, G 230, X 260, M 245. AD = 740 + 190 + 230 + (260 - 245) = 1,175. Depreciation lifts X to 280 and cuts M to 238. Net exports become 42 and AD = 1,202, a rise of 2.3%. Higher net exports add to AD, output and jobs. Costs: dearer imports, inflation if near capacity, and a gain that depends on how responsive trade is.

The basic accelerator. Firms want capital in proportion to the output they expect to sell, so net investment follows the change in output, not its level. Illustration (capital stock needs to be 1.5 times output; you will not be asked to calculate this):

Year	Output	Growth	Net investment
1	80	-	-
2	88	10.0%	12
3	96	9.1%	12
4	100	4.2%	6
5	100	0%	0
6	96	-4.0%	negative

In year 4 output still rises, yet net investment has halved. A slowdown in growth can hit investment, and with it AD, hard.

Determinants of saving. Saving is disposable income not spent. Income, interest rates, wealth, job security and expected inflation, access to credit, age structure and attitudes all affect it. Worked example: disposable income 640, consumption 560, saving 80, so 12.5% of disposable income is saved.

Saving versus investment

	Saving	Investment
Meaning	Income not spent	Spending on capital goods
Made by	Households (also firms and government)	Mainly firms
Circular flow	Withdrawal	Injection
Motive	Future consumption, security	Expected profit

They are decided by different people, so planned saving and planned investment may differ. Saving that is not matched by injections lowers national income.

5. Quick self-test

1. Nominal income is 880 and the price index is 110. Find real income.
2. Real income rises from 500 to 515. Find real growth.
3. Injections are 210 and withdrawals are 0.30Y. Find equilibrium income.
4. If full employment income is 760, how far below it is your answer to question 3?
5. C 420, I 110, G 130, X 150, M 165. Find AD.
6. State net exports in question 5.
7. Disposable income 320, consumption 280. Find saving as a fraction of disposable income.
8. Which curve shifts if wage costs rise, and in which direction?
9. Does a rise in the price level move AD or shift it?
10. Explain why investment can fall when growth merely slows.

Answers

1. 880 / 1.10 = 800.
2. 15 / 500 = 3.0%.
3. 0.30Y = 210, so Y = 700.
4. 760 - 700 = 60 below.
5. 420 + 110 + 130 + (150 - 165) = 645.
6. 150 - 165 = -15 (a deficit).
7. 40 / 320 = 0.125.
8. Short-run AS shifts left.
9. A movement along AD.
10. Investment depends on the rate of change of demand; when the rate falls, firms need fewer new machines, so net investment falls even as output rises.

Where marks are usually lost

• Using nominal figures when real is asked, or dividing by the index without the 100.
• Writing S = I as the equilibrium condition instead of J = W.
• Moving a curve for a change in the price level.
• Shifting AD for a cost shock, or short-run AS for a demand shock.
• Leaving axes and curves unnamed, or giving no equilibrium labels.
• Treating saving and investment as the same thing.
• Describing net exports as exports only.
• Stating a conclusion about a shock with no reference to spare capacity or the time period.

Official syllabus

Source: the AS and A-level Economics specification published by AQA (7135/7136, version 1.3, 29 June 2022), content sections 4.2.2.1 to 4.2.2.3 in the PDF (3.2.2.1 to 3.2.2.3 on the AQA website).