Aggregate Demand & Aggregate Supply | 4.2.2 | AQA A-Level Economics Notes

4.2.2.1 The Circular Flow of Income

• Real national income is an indicator of economic performance.
• If a measure is ‘real’, it accounts for inflation unlike nominal values.
• In an economy, households and firms interact, exchanging resources. Households supply factors of production such as labour, and firms pay wages for them. Firms supply goods and services to households, who pay for them.
• Income = output = expenditure.
• Injections are forms of spending that enters the circular flow of income.
• Injections include investment, government spending or exports.
• Withdrawals are leakages of spending from the circular flow.
• Withdrawals include imports, taxation and savings.
• When the rate of withdrawals equals the rate of injections, the economy reaches equilibrium.
• When the rate of injections is greater than the rate of withdrawals in an economy, there is an expansion of aggregate demand and real GDP, and vice versa (contraction).

4.2.2.2 Aggregate Demand and Aggregate Supply Analysis

• Changes in the price level are represented by movements along the aggregate demand (AD) and aggregate supply (AS) curves.
• Changes in the determinants of AD or AS will cause shifts in the curves.
• Short-run aggregate supply is different from long-run aggregate supply.
• Underlying economic growth is represented by a rightward shift in the LRAS curve.
• Demand and supply-side shocks can affect the economy. For example, changes in productivity or confidence.
• An economic shock is an unexpected event, and they can either be favourable or damaging to an economy.

4.2.2.3 The Determinants of Aggregate Demand

• Aggregate demand is the total planned spending on the goods and services produced within the economy in a particular time period.
• The AD curve is downward sloping because higher average price levels lead to a fall in real incomes, and therefore a fall in demand.
• AD = C + I + G + (X - M).
• Changes in consumption, investment, government spending, or net exports determine the level of aggregate demand in an economy.
• Consumer spending makes up more than 60% of an economy’s aggregate demand.
• Investment is the total planned spending by firms on the capital goods produced within the economy.
• The basic accelerator process shows that changes in investment can be directly linked to changes in the rate of growth of national income.
• Savings is income which is not spent, whilst investment is the spending by firms on capital goods.

4.2.2.4 Aggregate Demand and the Level of Economic Activity

• Changes in the level of AD can have implications on the average price level in an economy, and the level of national output. If there are changes in the national output, this can lead to changes in employment levels.
• Some of the factors that affect AD include employment, wage rates, confidence, shocks, taxes, interest rates, exchange rates.
• The multiplier is a relationship between an initial change in aggregate demand and national income.
• An initial change in expenditure (aggregate demand) leads to a larger impact on local or national income.
• For example, if the government spends on welfare, everybody’s income increases and this leads to larger changes in consumer spending.
• The marginal propensity to consume (MPC) is the proportion of an increase in income that is spent. Consumers on lower incomes usually have a higher MPC, closer to one.
• k = change in national income/ change in expenditure.
• k = 1/ 1- MPC = 1/ MPS.
• The marginal propensity to save/ withdraw is 1 – MPC. It is any increase in income that is not spent.
• The size of the MPC determines the magnitude of the multiplier effect because it shows how effective government spending will be in boosting consumer spending, confidence and the inflation rate.

4.2.2.5 Determinants of Short-run Aggregate Supply

• Aggregate supply is the aggregate level of real output that all the firms in an economy plan to produce at different average price levels.
• Short-run aggregate supply is the quantity of real output that firms plan to produce and sell at different price levels when the total productive capacity is fixed, but variable factors of production can change.
• The price level and production costs are the main determinants of SRAS.
• Changes in costs of production can be caused by changes in money wage rates, raw material prices, business taxation and productivity. These factors will cause shifts in the SRAS curve.

4.2.2.6 Determinants of Long-run Aggregate Supply

• LRAS is the real output that can be supplied when the economy is on its production possibility frontier. This is when all the available factors of production are employed and producing at their normal capacity level of output.
• The fundamental determinants of LRAS are technology, productivity, attitudes, enterprise, factor mobility, and economic incentives.
• The position of the vertical LRAS curve represents the normal capacity level of output of the economy.
• The institutional structure of the economy, such as the role of the banking system in providing business investment funds, is also important in determining aggregate supply.
• The Keynesian AS curve shows that even in the long run, a depressed economy can settle into an equilibrium that is below its full capacity.