OxfordAQA International AS and A-level Economics: Circular flow and AD and AS analysis (9640)

This guide is written for the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. It covers sections 3.2.2.1 (the circular flow of income), 3.2.2.2 (aggregate demand and aggregate supply analysis) and 3.2.2.3 (determinants of aggregate demand). Section 3.2 is International AS content, and the A-level builds on it. The quantitative skills in section 3.5 can be assessed in any unit, so the sums here practise QS2 (percentages), QS4 (graphs), QS5 (index numbers), QS7 (money to real terms) and QS9 (interpreting data). Every figure is invented and illustrative.

The multiplier calculation, the link between AD and the level of activity, and the detail of short-run and long-run aggregate supply are covered in other pages. Here you learn the model and its diagrams. Use the revision notes for recall and the practice questions to test yourself. Course pages: OxfordAQA A-level Economics hub and checklist. Not sure where to start? Take a free 10-minute diagnostic. For the indicators themselves, see measurement of macroeconomic performance.

What you must be able to do

Section	Specification content	What it means in practice
3.2.2.1	National income, nominal and real, the circular flow, injections and withdrawals	Convert to real terms, find equilibrium, trace a change
3.2.2.2	AD and AS analysis	Draw and use diagrams for shocks, growth and cyclical unemployment
3.2.2.3	Meaning, components and determinants of AD, savings, marginal propensities, saving versus investment, basic accelerator	Explain what shifts each component and calculate propensities

1. National income and the circular flow (3.2.2.1)

National income measures the value of the output produced, and the income earned, in an economy over a period. You do not need the detail of how national income accounts are built.

Nominal (money) income is measured at the prices of the year it is earned. Real income removes the effect of price changes, so it shows the change in the quantity of output. Real national income is the main indicator of macroeconomic performance, because only real changes tell you whether more is being produced.

Real value = nominal value ÷ price index × 100.

Worked example (Country A, invented). Nominal national income is 500 in year 1 (price index 100) and 567 in year 2 (price index 105).

• Real income in year 2 = 567 ÷ 105 × 100 = 540.
• Real growth = (540 − 500) ÷ 500 × 100 = 8%.
• Nominal growth = (567 − 500) ÷ 500 × 100 = 13.4%.

Nominal growth overstates the rise in output because part of it is higher prices.

Real national income is an important indicator but not a full measure of well-being. It ignores how income is shared, unpaid and informal work, leisure time, working conditions and environmental damage, and it says nothing about the quality of what is produced.

The circular flow model

Households supply factors of production to firms and receive income. Firms supply output to households and receive spending. The model rests on the identity income = output = expenditure: every pound of output is someone’s income and someone’s spending.

Households --- consumption spending C ---> Firms
Households <-- wages, rent, interest, profit --- Firms
Leakages out of the flow: saving S, taxes T, imports M
Additions into the flow: investment I, government spending G, exports X

• Withdrawals (W) are income not passed on as spending on domestic output: saving, taxes and spending on imports.
• Injections (J) are spending that does not come from households’ income in the current flow: investment, government spending and exports.

Equilibrium national income is where J = W. Above it, W exceeds J, spending falls short of output and income falls. Below it, J exceeds W and income rises. Full employment income is the level at which all resources that are available and wanted are employed. Equilibrium can lie below it, which means spare capacity.

Worked example (Country A). Withdrawals are 0.35 of income (saving 0.10, taxes 0.15, imports 0.10). Injections: investment 60, government spending 70, exports 80, so J = 210.

• Equilibrium: 0.35Y = 210, so Y = 600.
• At Y = 500, W = 175 and J = 210, so J exceeds W by 35 and income rises.
• At Y = 700, W = 245, so W exceeds J by 35 and income falls.
• Full employment income is 650, so equilibrium is 50 below it, 7.7% of full employment income.

Now exports rise by 14. J = 224, so Y = 224 ÷ 0.35 = 640. Income rises by 40, more than the 14 injected. Why the rise is bigger is the multiplier process, covered separately. Suppose instead the tax rate rises so that withdrawals are 0.40 of income. Then Y = 210 ÷ 0.40 = 525, a fall of 75. Rule: a rise in injections raises equilibrium income, a rise in withdrawals lowers it.

2. AD and AS analysis (3.2.2.2)

The diagram has the price level on the vertical axis and real GDP (real national income) on the horizontal axis.

• A change in the price level moves you along AD and along short-run aggregate supply (SRAS). It does not shift either curve.
• A change in any other influence on AD shifts the AD curve. A change in costs shifts SRAS.
• Long-run aggregate supply (LRAS) is drawn vertical at the economy’s full capacity output. Underlying economic growth is a rightward shift of LRAS.
• Macroeconomic equilibrium is where AD meets SRAS, at one price level and one level of real GDP.

Event	Curve and direction	Price level	Real GDP
Consumer confidence rises	AD right	Up	Up
Government cuts spending	AD left	Down	Down
Wage costs rise across the economy	SRAS left	Up	Down
Productivity improves, costs fall	SRAS right	Down	Up
Capacity grows (more capital, better skills)	LRAS right	Down, if AD is unchanged	Up

Worked example (invented model). AD: P = 220 − 0.2Y. SRAS: P = 40 + 0.1Y. Setting them equal: 0.3Y = 180, so Y = 600 and P = 100.

• Demand-side shock. A fall in export orders shifts AD to P = 214 − 0.2Y. Then 0.3Y = 174, so Y = 580 and P = 98. Real GDP falls 3.3% and the price level falls 2%.
• Supply-side shock. A rise in imported raw material prices shifts SRAS to P = 58 + 0.1Y. Then 0.3Y = 162, so Y = 540 and P = 112. Real GDP falls 10% while the price level rises 12%.

A demand-side shock moves price and output in the same direction. A supply-side shock to costs moves them in opposite directions. That is how you tell them apart in data.

Demand-deficient (cyclical) unemployment. If AD falls and real GDP ends below the LRAS level, firms need fewer workers. Unemployment rises because spending is too low, not because workers lack the right skills.

Economic growth. Short-run growth is a rightward AD shift that uses spare capacity. Underlying growth is a rightward LRAS shift. If LRAS moves from 650 to 676, capacity has grown 4%.

Global events. A slowdown abroad cuts export demand and shifts AD left. A rise in world commodity prices raises costs and shifts SRAS left. Faster growth among trading partners does the reverse. Trace the route in your answer: event, component or cost, curve, price level and output.

The factors behind SRAS and LRAS shifts are covered in detail on other pages. For AD, see section 3 below.

3. Determinants of aggregate demand (3.2.2.3)

Aggregate demand is the total planned spending on an economy’s output at each price level over a period. AD = C + I + G + (X − M).

Component	Main determinants
Consumption (C)	Disposable income, interest rates, wealth (house and share prices), consumer confidence, availability of credit, taxes
Investment (I)	Interest rates, expected returns and business confidence, corporate taxes, technology, growth of demand, availability of finance
Government spending (G)	Political decisions on public services and welfare, the state of the economy, the budget position
Exports (X)	Foreign incomes, the exchange rate, relative prices and quality, trade barriers
Imports (M)	Domestic income, the exchange rate, relative prices, tastes

Net exports are X − M. A rise in domestic income raises imports, which reduces net exports. A fall in the exchange rate makes exports cheaper abroad and imports dearer, which usually raises net exports. A global recession cuts X and lowers AD, so a global event reaches the domestic economy through net exports.

Determinants of saving. Saving is the part of income not spent. It rises with disposable income, and with the interest rate because the reward for saving is higher. It also depends on wealth, expectations about the future, access to credit and attitudes to thrift.

Marginal propensities

• MPC = change in consumption ÷ change in disposable income.
• MPS = change in saving ÷ change in disposable income. MPC + MPS = 1.
• MPT = change in taxes ÷ change in national income.
• MPM = change in imports ÷ change in national income.

Worked example. Disposable income rises from 400 to 460 and consumption from 330 to 375. Saving moves from 70 to 85.

• MPC = 45 ÷ 60 = 0.75.
• MPS = 15 ÷ 60 = 0.25, and 0.75 + 0.25 = 1.
• National income rises by 100, tax revenue by 18 and imports by 12: MPT = 0.18 and MPM = 0.12.

Saving and investment

Saving is income not spent on consumption. It is a withdrawal. Investment is spending on capital goods, such as machines and buildings, that add to future productive capacity. It is an injection and a component of AD. Saving can help fund investment through banks, but the two are decided by different people for different reasons, so they need not be equal.

The basic accelerator

The accelerator links investment to the rate of change of output. Firms hold capital to produce output, so a larger output needs more capital. Suppose each unit of output needs 3 units of capital (illustrative, and no calculation of this kind is required).

Output	Capital needed	Net investment	Output growth
200	600	none	none
220	660	60	10%
240	720	60	9.1%
250	750	30	4.2%
250	750	0	0%

Net investment halves between the third and fourth rows although output is still rising, because growth is slowing. Investment is therefore volatile, and a small change in the growth rate can cause a large change in AD.

Common errors

• Showing a price rise as a rightward shift of AD. A price change is a movement along the curve.
• Calling saving an injection, or investment a withdrawal.
• Quoting nominal growth as growth of output.
• Using “demand-pull” and “cost-push” without naming the curve that shifts and the direction.
• Treating the accelerator as a link between investment and the level of income rather than its change.

Next steps

Work through the practice questions, then check recall with the revision notes. Tick off outcomes on the checklist.

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.