OxfordAQA A-level Economics: Circular flow and AD and AS analysis (9640) – Revision Notes

These notes condense sections 3.2.2.1 to 3.2.2.3 of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2: the circular flow of income, AD and AS analysis, and the determinants of aggregate demand. Section 3.2 is International AS content. For full explanations start with the study guide, then test yourself with the practice questions. Course pages: hub and checklist. Unsure what to revise first? Try a free 10-minute diagnostic. All figures are invented and illustrative.

Key definitions

Term	Meaning
National income	Value of output produced, and income earned, over a period
Nominal (money) income	Measured at the prices of the year it is earned
Real income	Nominal income adjusted for price changes
Injections (J)	Investment, government spending, exports
Withdrawals (W)	Saving, taxes, imports
Equilibrium income	The level where J = W
Full employment income	Output when all available and wanted resources are in use
Aggregate demand	Total planned spending on domestic output at each price level
Underlying growth	A rightward shift of LRAS
Cyclical (demand-deficient) unemployment	Unemployment caused by too little AD

Formulas

Result	Formula
Real value	nominal ÷ price index × 100
Growth rate	(new − old) ÷ old × 100
Identity	income = output = expenditure
Equilibrium	J = W, so Y = J ÷ marginal propensity to withdraw (when withdrawals are a fixed share of income)
AD	C + I + G + (X − M)
MPC and MPS	MPC = ΔC ÷ ΔYd, MPS = ΔS ÷ ΔYd, MPC + MPS = 1
MPT and MPM	ΔT ÷ ΔY and ΔM ÷ ΔY

Method boxes

Converting to real terms.

1. Divide the nominal figure by the price index.
2. Multiply by 100.
3. Compare real figures to find real growth.

Reminder: nominal income 800 in year 1 (index 100) and 848 in year 2 (index 106). Real year 2 = 848 ÷ 106 × 100 = 800. Nominal growth is 6%, real growth is 0%.

Finding circular flow equilibrium.

1. Add the injections.
2. Add the marginal propensities to withdraw.
3. Divide injections by that total.
4. Check by confirming W = J at that income.

Reminder: J = 150 and withdrawals are 0.40 of income, so Y = 150 ÷ 0.40 = 375. At Y = 400, W = 160, above J, so income falls toward 375.

Using an AD/AS diagram.

1. Label the axes: price level and real GDP.
2. Decide which curve moves, and the direction.
3. Mark the old and new equilibrium.
4. State the change in price level and real GDP.
5. Link back to unemployment or growth if asked.

Must-know distinctions

• Movement or shift. A change in the price level is a movement along AD or SRAS. Anything else that changes planned spending shifts AD.
• Nominal or real. Only real changes show a change in output.
• Saving or investment. Saving is income not spent and a withdrawal. Investment is spending on capital goods and an injection.
• Demand-side or supply-side shock. A shift of AD moves price level and output the same way. A cost shock to SRAS moves them in opposite ways.
• Short-run or underlying growth. Using spare capacity is an AD shift. A bigger capacity is an LRAS shift.
• Marginal propensity or average share. Marginal measures the extra, not the total.

What shifts each component of AD

Component	Rises when	Falls when
C	Disposable income, wealth, confidence rise; interest rates fall; credit is easier	The opposite
I	Expected returns rise; interest rates fall; output growth speeds up	The opposite
G	Government decides to spend more	Government decides to cut
X	Foreign incomes rise; the exchange rate falls	Foreign incomes fall; the exchange rate rises
M	Domestic income rises; the exchange rate rises	Domestic income falls; the exchange rate falls

Net exports = X − M. Reminder: X = 90 and M = 70 gives 20. If X falls to 84 and M rises to 73, net exports are 11, a fall of 9, and AD shifts left.

Worked reminders

Marginal propensities. Disposable income rises from 300 to 340 and consumption from 250 to 280. MPC = 30 ÷ 40 = 0.75 and MPS = 10 ÷ 40 = 0.25. If national income rises by 80 and tax revenue by 12, MPT = 0.15. If imports rise by 8, MPM = 0.10.

Shock in numbers. AD: P = 190 − 0.15Y and SRAS: P = 10 + 0.15Y give Y = 600 and P = 100. A cost shock moves SRAS to P = 22 + 0.15Y, so Y = 560 and P = 106. Real GDP falls 6.7% and the price level rises 6%. Price up and output down points to a supply-side shock.

Reading data. If prices and real GDP both fall, suspect an AD shift left. If prices rise and real GDP falls, suspect an SRAS shift left. If real GDP and capacity both rise with little price pressure, suspect an LRAS shift right.

Effects of changes in the circular flow

Change	Effect on equilibrium income	Reason
Higher investment	Rises	J greater than W until income rises
Higher government spending	Rises	Same
Higher exports	Rises	Foreign spending adds to the flow
Higher saving rate	Falls	W greater than J until income falls
Higher taxes	Falls	Less is left to spend
Higher spending on imports	Falls	Spending leaks abroad

Always end with the new income being above or below full employment income, since that decides whether there is spare capacity.

Determinants of saving

Saving rises with disposable income, higher interest rates, uncertainty about the future and cultural attitudes to thrift. It falls with easier credit, rising wealth that makes people feel secure, and expectations of higher future income. Linking this to the circular flow: if households save more, C falls and W rises, so equilibrium income tends to fall.

Limits of real national income

Real national income per head is a better guide to living standards than the total. Even so, it does not show how income is shared, how much unpaid work is done, how much leisure people have, or how much damage output does to the environment. Use these as evaluation points when asked whether higher real income means higher well-being.

Chains of reasoning to practise

• Global recession → fall in foreign incomes → fall in X → AD left → lower real GDP and lower price level → demand-deficient unemployment.
• Rise in world raw material prices → higher firms’ costs → SRAS left → higher price level, lower real GDP.
• Rise in interest rates → higher cost of borrowing and reward for saving → lower C and I → AD left.
• Investment in skills and capital → higher capacity → LRAS right → underlying growth.

For evaluation, weigh the size of the shift, how long it lasts, how far spare capacity exists, and whether the price level or output absorbs most of the change.

The basic accelerator

Investment depends on the rate of change of output, not its level. If output keeps rising but at a slower rate, net investment falls. If output is constant, net investment is zero. This makes investment volatile. No calculation is required on this point.

Quick self-test

1. Nominal national income is 1,248 in year 2 with a price index of 104 (year 1 index 100). Find real income in year 2.
2. State two items that are injections and two that are withdrawals.
3. Withdrawals are 0.25 of income and injections are 100. Find equilibrium income.
4. Injections then rise to 120. Find the new equilibrium income and the change.
5. Disposable income rises by 50 and consumption by 40. Find the MPC and MPS.
6. State whether a rise in the price level shifts AD.
7. Which curve shifts, and which way, if firms’ energy costs rise across the economy?
8. Name the component of AD that falls first if a country’s trading partners go into recession.
9. Give one reason why real national income may overstate well-being.
10. Explain why investment can fall while output still grows.

Answers

1. 1,248 ÷ 104 × 100 = 1,200.
2. Injections: investment, government spending, exports (any two). Withdrawals: saving, taxes, imports (any two).
3. Y = 100 ÷ 0.25 = 400.
4. Y = 120 ÷ 0.25 = 480, a rise of 80.
5. MPC = 40 ÷ 50 = 0.8. MPS = 10 ÷ 50 = 0.2.
6. No. It is a movement along AD.
7. SRAS shifts left.
8. Exports.
9. Any one: it ignores income distribution, unpaid work, leisure or environmental damage.
10. Net investment depends on the change in output. If growth slows, less new capital is needed, so net investment falls.

Where marks are usually lost

• Writing “AD shifts because prices rise” instead of a movement along the curve.
• Leaving the axes unnamed in a description of a diagram.
• Treating saving as an injection.
• Using nominal figures when asked about growth in output.
• Giving a calculation with no working or no units.
• Stating a shift without saying what happens to both price level and real GDP.
• Listing determinants without explaining the route to the component.
• Evaluating with a vague “it depends” and no reason.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), version 1.2, first teaching September 2020, published by OxfordAQA. Sections 3.2.2.1, 3.2.2.2 and 3.2.2.3, with section 3.5 quantitative skills.