How the macroeconomy works, circular flow of
income, AD/AS analysis and related concepts
The circular flow of income
National income
Total value of the goods + services a country produces - output in one year.
Measured by GDP, GNP and GNI.
The circular flow of income
Firms and households interact and exchange resources in an economy.
Households supply firms with the factors of production e.g. labour +
capital, and in return, they receive wages and dividends.
Firms supply goods and services to households. Consumers pay firms for
these. This spending and income circulates around the economy in the
circular flow of income. Saving income removes it from the circular flow.
Taxes are also a withdrawal of income, whilst government spending on
public and merit goods, and welfare payments, are injections into the
economy.
International trade - exports are an injection into the economy. Imports are a
withdrawal from the economy. Full employment income is the total output
of an economy when unemployment is minimised or is at the government
target. This accounts for frictional unemployment.
,It is important to remember that income = output = expenditure in the
circular flow.
The economy reaches a state of equilibrium when the rate of withdrawals =
the rate of injections. The amount of savings in an economy is equal to the
amount of investment. In the UK, there is a traditionally low savings rate,
especially during economic growth.
Net injections into the economy will expand national output. Net
withdrawals from the economy will contract production, so output
decreases.
Aggregated demand and aggregated supply analysis
Aggregate demand
The total demand in the economy. It measures spending on goods and
services by consumers, firms, the government and overseas consumers
and firms.
Moving along the AD curve:
, A fall in the price level from P1 to P2 causes an expansion in demand from
Y1 to Y2. A rise in the price level from P2 to P1 causes a contraction in
demand from Y2 to Y1.
The downward slope of the AD curve can be explained by:
● Higher prices - fall in real incomes - goods + services become less
affordable in real terms
● High inflation - high price level - imports seem relatively cheaper. More
imports - deficit on the current account increases - AD would fall
● High inflation - higher interest rates. This will discourage spending,
since saving becomes more attractive + borrowing becomes expensive
Shifting the AD curve:
The AD curve is shifted by changes in the components of AD (C, I, G or X-M):
