OCR A Level Economics: The circular flow, propensities and aggregate demand (H460)

This guide teaches the Circular flow of income and Aggregate demand (AD) topics of the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. They sit in the macroeconomics content, under Aggregate demand and aggregate supply. The specification labels no content AS or Extension: all of it is A Level. Every figure below is invented and illustrative.

Track progress with the OCR Economics hub and checklist, find weak spots with the free diagnostics, recall with the revision notes and test yourself with the practice set. The wider course is in the macroeconomics overview.

What you must be able to do

Specification statement	Where it is covered
Explain the income, output and expenditure methods of measuring national income	Section 1
Explain the circular flow; injections and leakages; physical versus monetary flows	Sections 2 and 3
Explain average and marginal propensities to consume and save; the marginal propensity to withdraw (MPS, marginal rate of tax, MPM); calculate them	Sections 4 and 5
Explain aggregate demand and the determinants of its components	Sections 6 and 7
Evaluate the relationship between changes in income and consumption	Section 8
Evaluate how the accelerator theory explains the level of investment	Section 9
Explain the relationship between AD and the price level; why the AD curve may shift	Sections 10 and 11

The multiplier, aggregate supply and the AD/AS model have their own units; this guide stops at the shift in AD.

1. Measuring national income

National income can be measured in three ways, and in principle all three give the same total because every unit spent is someone’s output and someone’s income.

• Output method: add the value added by each sector. Value added is the value of a firm’s output minus the cost of the inputs bought from other firms. Adding final values only, or value added at each stage, avoids double counting.
• Income method: add the incomes earned by the factors of production: wages and salaries, rent, interest and profit, including self-employment income.
• Expenditure method: add spending on final goods and services: C + I + G + (X − M).

Worked example (Country A, cu billion, illustrative).

Output method	cu bn	Income method	cu bn	Expenditure method	cu bn
Agriculture	60	Wages	560	Consumption C	600
Manufacturing	280	Profits	260	Investment I	150
Construction	90	Rent	100	Government G	200
Services	570	Self-employment	80	Exports X	180
				Imports M	−130
Total	1,000	Total	1,000	Total	1,000

Expenditure: 600 + 150 + 200 + (180 − 130) = 1,000. Net exports are 50.

Double counting. A farm sells wheat for 30 to a mill, the mill sells flour for 50 to a baker, and the baker sells bread for 90. Value added: 30, then 50 − 30 = 20, then 90 − 50 = 40, a total of 90. Adding the sales (30 + 50 + 90 = 170) would count the wheat three times.

2. The circular flow of income

In the circular flow model, households supply factor services to firms in return for income, then spend that income on what firms produce.

• In the simple two-sector model (households and firms) all income is spent, so the flow is constant.
• Adding the financial sector, government and overseas sector gives three types of leakage and three of injection.

Leakages (withdrawals, W) take money out of the spending stream:

• saving (S)
• taxation (T)
• spending on imports (M)

Injections (J) put money in:

• investment (I)
• government spending (G)
• exports (X)

The flow is in equilibrium when W = J. If J > W, more money enters than leaves, so national income tends to rise. If W > J, it tends to fall.

Worked example. Country B has S = 90, T = 210, M = 120, and I = 100, G = 200, X = 110 (cu bn).

• W = 90 + 210 + 120 = 420
• J = 100 + 200 + 110 = 410
• W exceeds J by 10, so income tends to fall until withdrawals match injections again.

Saving is a leakage because it is not passed on as spending; it returns as investment only if the financial sector lends it to firms.

3. Physical and monetary flows

Physical (real) flows are movements of resources, goods and services. Households supply labour, land and capital services to firms, and firms supply goods and services to households.

Monetary flows are the payments that move in the opposite direction: wages, rent, interest and profit paid to households, and consumer spending paid to firms.

A baker employs a worker: labour flows to the bakery and the wage flows to the worker. The worker buys a loaf: bread flows to the household and the payment flows to the bakery. Each physical flow has a monetary flow in the opposite direction.

4. Average and marginal propensities

Propensities describe how households divide income. Use disposable income (Yd) when working with households.

Measure	Formula
Average propensity to consume (APC)	C / Yd
Average propensity to save (APS)	S / Yd
Marginal propensity to consume (MPC)	ΔC / ΔYd
Marginal propensity to save (MPS)	ΔS / ΔYd

Since income is either consumed or saved, APC + APS = 1 and MPC + MPS = 1. This holds when the base is disposable income. The average measures relate to the whole income and the marginal measures to the change in income.

Worked example (a household group in Country C, cu).

Yd	C	S = Yd − C	APC	APS
100	90	10	0.90	0.10
200	170	30	0.85	0.15
300	250	50	0.833	0.167
400	330	70	0.825	0.175

From 100 to 200: MPC = (170 − 90) / (200 − 100) = 80 / 100 = 0.8, so MPS = 30 − 10 over 100 = 0.2. Every step gives MPC = 0.8. APC falls as income rises because the household spends only 80% of each extra unit, but spent 90 when Yd was 100.

5. The marginal propensity to withdraw

Households can leave the spending stream in three ways, so the marginal propensity to withdraw (MPW) is the share of an extra unit of national income that is withdrawn:

MPW = MPS + marginal rate of tax (MRT) + marginal propensity to import (MPM)

• MRT = ΔT / ΔY
• MPM = ΔM / ΔY
• MPS = ΔS / ΔY

The share re-spent on domestically produced goods is 1 − MPW. The average propensity to withdraw is W / Y.

Worked example 1. National income rises by 100. Saving rises by 10, tax revenue by 20 and imports by 15.

• MPS = 10/100 = 0.10, MRT = 20/100 = 0.20, MPM = 15/100 = 0.15
• MPW = 0.10 + 0.20 + 0.15 = 0.45
• Re-spent on domestic output: 1 − 0.45 = 0.55

Worked example 2. Country D’s national income rises from 800 to 1,000. Saving moves from 80 to 110, tax from 160 to 210, imports from 120 to 160.

• MPS = 30/200 = 0.15; MRT = 50/200 = 0.25; MPM = 40/200 = 0.20
• MPW = 0.15 + 0.25 + 0.20 = 0.60
• Average propensity to withdraw: at 800, (80 + 160 + 120)/800 = 0.45; at 1,000, (110 + 210 + 160)/1,000 = 0.48

The average rises because the marginal rate (0.60) exceeds the average (0.45).

6. Aggregate demand

Aggregate demand is planned spending on the output of an economy during a period, at each possible price level:

AD = C + I + G + (X − M)

AD is planned spending at each price level; measured national expenditure is what took place.

7. Determinants of the components of AD

Consumption (C):

• disposable income, which changes with income, taxes and benefits
• interest rates: a rise makes borrowing dearer and saving more attractive
• wealth, such as rising house or share prices
• consumer confidence and expectations about jobs, income and prices
• availability and cost of credit

Investment (I):

• interest rates, because they are the cost of borrowing and the return given up by using retained profit
• expected returns and business confidence; Keynes called swings in confidence “animal spirits”
• changes in output, which is the accelerator (Section 9)
• technology and corporation tax
• availability of finance

Government spending (G): political and policy decisions, tax revenue, the state of the economy and the size of any deficit.

Net exports (X − M):

• the exchange rate: a higher rate makes exports dearer abroad and imports cheaper
• relative price levels and quality
• income abroad, which drives export demand
• trade barriers
• the home country’s own income level, which raises imports

Chain (interest rates). Lower rate → cheaper borrowing, less reward for saving → higher C and I → higher AD.

8. Income and consumption (evaluation)

The simple relationship is a consumption function: C = a + b·Yd, where a is autonomous consumption (spending even at zero income) and b is the MPC. Higher income raises consumption, but by less than the rise in income when MPC < 1.

Worked example. If a = 50 and b = 0.8: at Yd = 400, C = 50 + 0.8 × 400 = 370; at Yd = 500, C = 450. The change in C is 80 for a rise of 100 in Yd, as MPC = 0.8 says.

Evaluation points:

• Income level: the MPC is usually higher for low-income households, so who receives extra income matters.
• Expectations: a rise seen as temporary may be saved, a rise seen as lasting spent.
• Wealth, credit and interest rates can change consumption without any income change.
• Time: consumption may respond with a lag.

Overall, income is the main determinant, but the link is not fixed.

9. The accelerator theory of investment

The accelerator ties investment to how fast output is changing. Let v be the capital-output ratio, the units of capital needed to produce one unit of output. Net investment = v × ΔY.

Worked example. v = 3, replacement investment = 20 each year (illustrative).

Year	Output Y	ΔY	Capital needed (3Y)	Net investment	Gross investment
1	100		300
2	110	+10	330	30	50
3	125	+15	375	45	65
4	135	+10	405	30	50
5	135	0	405	0	20
6	130	−5	390	−15	5

Output rises in year 4 but gross investment falls from 65 to 50, because output grew more slowly. Investment depends on how fast output grows, so a small change in output growth causes a larger change in investment.

Evaluation of the theory:

• Strength: explains why investment is volatile.
• Spare capacity: if firms have idle capital, extra output needs no new investment.
• Expectations: firms invest only if growth is expected to last.
• Finance and interest rates can block investment even when output grows.
• The capital-output ratio changes with technology, so v is not constant.

10. AD and the price level

The AD curve slopes downward. Axes: price level on the vertical axis, real output (real GDP) on the horizontal. A higher price level reduces the quantity of real output demanded, for three reasons:

1. Wealth effect: higher prices reduce the real value of money wealth, so households spend less.
2. Interest rate effect: higher prices increase the demand for money, which pushes interest rates up and reduces C and I.
3. International trade effect: higher domestic prices make exports less competitive and imports relatively cheaper, so X − M falls.

A new price level means a movement along the AD curve. Anything else that changes planned spending at every price level causes a shift.

11. Why the AD curve shifts

A change in any component at each price level shifts AD. A rise shifts the curve right; a fall shifts it left.

Event	Component	Shift
Consumer confidence falls	C	Left
Lower interest rates	C and I	Right
Government cuts spending	G	Left
Overseas incomes rise	X	Right
Exchange rate rises	X down, M up	Left

Worked example. At each price level, C rises by 15, I falls by 10, G rises by 20, X rises by 5 and M rises by 8. The initial change in AD = 15 − 10 + 20 + 5 − 8 = +22, a shift to the right. Note that a rise in imports reduces AD, so M enters with a negative sign.

Common errors

• Writing MPC + MPS = 1 using national income when taxes and imports exist; use disposable income.
• Stating the accelerator as “investment depends on output” instead of its change.

Official syllabus

This guide is aligned to the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021, published by OCR.