Pearson Edexcel International Advanced Level Economics: Aggregate supply, circular flow, equilibrium (YEC11)

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (YEC11), Issue 2, June 2018. It covers specification sections 2.3.3 (aggregate supply) and 2.3.4 items 1 to 3 (the circular flow, injections and withdrawals, and equilibrium real output). In the specification, the IAS label belongs to Units 1 and 2, and the extra IA2 content is Units 3 and 4. Your topic sits in Unit 2: it is IAS content, and it carries on into the complete International Advanced Level.

Use it with the revision notes and the practice set. The course hub, the printable checklist and the free diagnostics sit alongside. All countries, firms and figures below are invented for illustration.

What this guide covers

Specification	You must be able to
2.3.3 item 1	Explain the concept of AS, draw the AS curve, and tell a movement along it from a shift
2.3.3 item 2	Explain how raw material and energy costs, exchange rates and tax rates move SRAS
2.3.3 item 3	Draw Keynesian and classical LRAS curves; explain what moves LRAS
2.3.4 item 1	Describe the circular flow of income; distinguish income from wealth
2.3.4 item 2	Separate injections (investment, government spending, exports) from withdrawals (saving, taxation, imports); explain net injections and net withdrawals
2.3.4 item 3	Explain equilibrium real national output and how AD and AS shifts change it

The multiplier, which also sits in 2.3.4, has its own unit elsewhere, so it is left out of this guide.

Aggregate supply: the concept and the curve (2.3.3 item 1)

Aggregate supply (AS) is the planned real output of every firm in the economy added together, at each general price level, over a set period. The AS curve slopes upward in the short run: the vertical axis is the general price level and the horizontal axis is real national output.

A movement along the curve happens when the general price level alters. The AS curve is drawn for given costs, so a higher price level raises profit per unit and firms supply more.

A shift of the curve is caused by anything other than the price level that changes the cost or capacity of producing output. Costs fall: SRAS shifts right (more output at every price level). Costs rise: SRAS shifts left. Never say a change in the price level shifts AS.

Short-run AS (2.3.3 item 2)

The short run is the period in which at least one factor of production, usually capital, is fixed. SRAS responds to unit costs.

Raw materials and energy. If the price of a widely used input rises, unit costs rise at every level of output and SRAS shifts left. This is cost-push pressure.

Exchange rates. A fall in the exchange rate raises the home-currency price of imported inputs.

Worked example. Country A’s firms buy a fuel priced at 40 units of foreign currency a tonne. When 1 unit of Country A’s currency buys 0.50 foreign units, a tonne costs 40 ÷ 0.50 = 80 home units. After depreciation, 1 home unit buys 0.40 foreign units, so a tonne costs 40 ÷ 0.40 = 100 home units. That is a 25% rise: (100 − 80) ÷ 80 × 100. If the fuel makes up 30% of a firm’s costs, unit costs rise by about 0.30 × 25% = 7.5%. SRAS shifts left. A rise in the exchange rate does the reverse.

Tax rates. Taxes that firms pay as a cost of employing people or selling goods raise costs.

Worked example. A small bakery employs 50 people at 400 a week each, so wages are 20,000. Employer tax rises from 10% to 12% of wages: the bill goes from 2,000 to 2,400, up 400 a week, or 8 per worker. Total weekly cost rises from 22,000 to 22,400, a rise of about 1.8%. Spread across many firms, SRAS shifts left. Lower employer taxes would shift it right. Link tax to costs in your answer; do not simply say “tax goes up so supply falls”.

Long-run AS (2.3.3 item 3)

In the long run all factors can change, so LRAS is about productive capacity: the output the economy can produce when resources are fully used.

Two shapes the specification names

Classical LRAS is vertical at the full-employment level of output. Output depends on the quantity and quality of resources, not on the price level, so a rise in AD changes only prices in the long run.

Keynesian LRAS has three sections:

Price
level |                   |   <- section 3: vertical, full capacity
      |                  |
      |               /      <- section 2: upward sloping
      |             /
      |___________/          <- section 1: horizontal, spare capacity
      +------------------------- Real national output

Section 1 has plenty of spare capacity, so output can rise with no pressure on prices. In section 2 bottlenecks appear and firms bid up costs, so output and prices rise together. Section 3 is the limit: more AD only raises prices.

Worked example. Country B’s Keynesian curve: price level 50 up to output 600 (cu billion, illustrative), then price = 50 + 0.2 × (output − 600) up to output 1,000, then vertical.

AD shift	Output	Price level	Change
450 to 550 (section 1)	+22.2%	50 to 50	prices 0%
700 to 800 (section 2)	+14.3%	70 to 90	prices +28.6%
Along section 3 (output stays 1,000)	0%	130 to 150	prices +15.4%

The same AD boost has a different mix of output and price effects depending on where the economy sits.

Factors that shift LRAS

• State of technology. Better methods raise output from the same resources.
• Productivity. Output per worker or per hour.
• Education and skills. Raises the quality of labour and productivity.
• Government regulations and tax. Lighter, well-designed rules and lower tax on enterprise can raise capacity; heavier rules can reduce it.
• Demography and net migration. More working-age people, or net inflow of workers, raises the labour force.
• Competition policy. More rivalry pushes firms to cut costs and innovate.

Worked example. Country C has 40 million workers producing 960 billion (24,000 each). Later, net migration lifts employment to 42 million, and productivity rises to 25,000 each. Output = 42m × 25,000 = 1,050 billion, up 9.375%. The workforce grew 5% and productivity 4.17% (25,000 ÷ 24,000 − 1), and 1.05 × 1.0417 = 1.09375. LRAS shifts right, and with unchanged AD, the equilibrium price level falls.

The circular flow of income and wealth (2.3.4 item 1)

The circular flow shows money, goods and services moving around the economy. Households supply labour and other factors to firms and receive income (wages, rent, interest, profit). Firms produce goods and services; households spend income on them. The flow is income = output = expenditure, which links to the idea of national income and AD.

The basic model adds withdrawals (leakages) that take money out of the flow and injections that put money in.

Income and wealth. Income is a flow: an amount received per period, such as per year. Wealth is a stock: what you own, valued on one date, such as property, shares and savings. Saving takes some income and adds it to wealth.

Worked example. A household has income of 30,000 a year and wealth of 90,000. If it saves 10% of income, it adds 3,000 to wealth, giving 93,000 (assuming asset prices are unchanged). The two measures are not the same: a retired person may have low income and high wealth.

Injections and withdrawals (2.3.4 item 2)

Injections (J)	Withdrawals (W)
Investment (I)	Saving (S)
Government expenditure (G)	Taxation (T)
Exports (X)	Imports (M)

The distinction is whether money enters the circular flow of spending on domestic output (injections) or leaves it (withdrawals).

Net effect. When J > W (a net injection), spending on domestic output exceeds the income leaving the flow, so output tends to rise. When W > J (a net withdrawal), output tends to fall. When J = W, the flow is stable.

Worked example. Country D’s flows (illustrative, cu billion): S = 120, T = 150, M = 130 so W = 400. I = 110, G = 160, X = 120 so J = 390. Net withdrawal = −10. Check with AD: consumption of all goods = income − S − T = 1,000 − 270 = 730. AD = 730 + 110 + 160 + 120 − 130 = 990, which is less than output of 1,000. Unsold output of 10 pushes firms to cut production. If G rises by 40, J = 430, net injection = +30, and output tends to rise. How much it rises depends on the multiplier, covered in its own unit.

Equilibrium real output (2.3.4 item 3)

Equilibrium real national output is where AD equals AS, so planned spending matches planned production. A shift in either curve changes equilibrium output and the price level.

Shift	Output	Price level
AD right	rises	rises
AD left	falls	falls
SRAS right	rises	falls
SRAS left	falls	rises

Worked example (illustrative). AD: output = 1,400 − 4P. SRAS: output = 800 + 4P.

1,400 − 4P = 800 + 4P  so 8P = 600  so P = 75, output = 1,100.

• Cost shock, SRAS becomes 720 + 4P: P = 680 ÷ 8 = 85, output = 1,060. Prices up 13.3%, output down 3.6%.
• AD rises by 80 (1,480 − 4P): P = 85, output = 1,140.
• SRAS rises by 60 (860 + 4P): P = 67.5, output = 1,130.

With classical LRAS at output 1,200, AD (1,400 − 4P) gives long-run price level 50. If LRAS shifts to 1,260, price level falls to 35.

Evaluation chain. A rise in AD raises output only if there is spare capacity. If the economy is on Keynesian section 1 or 2, output rises; on classical or section 3, prices rise. The time period matters, as does whether the shift is expected.

Common errors

• Saying a rise in the price level shifts AS. It is a movement along.
• Treating “SRAS shifts left” and “LRAS shifts left” as the same event. Cost shocks move SRAS; capacity changes move LRAS.
• Mixing up income (flow) and wealth (stock).
• Counting saving as an injection. It is a withdrawal.
• Drawing a classical LRAS and then saying AD raises output in the long run.
• Quoting a percentage change without showing the base value.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, Pearson Education Limited: Unit 2, sections 2.3.3 and 2.3.4.