Injections, withdrawals and equilibrium

In the simplest model, households supply factors to firms and receive income; they spend that income on firms' output. National output = national income = national expenditure — three ways of measuring the same flow, which is why they must be equal.

The real economy adds leaks and top-ups:

• Injections (J) — spending that enters the flow from outside household consumption: Investment (I) + Government spending (G) + Exports (X).
• Withdrawals / leakages (W) — income not passed on to domestic firms: Savings (S) + Taxation (T) + Imports (M).

The paradox of thrift: saving is prudent for one household but if everyone saves more at once, withdrawals exceed injections, AD falls, firms cut output and jobs, and incomes fall — so total saving may not even rise. Keynes's most famous fallacy of composition, and the intellectual root of the case for a fiscal stimulus in a recession.

AD = C + I + G + (X − M)

Consumption (C) — about 60% of UK AD, the biggest component. Determined by: real disposable income (the main driver), interest rates (cost of borrowing and reward for saving), consumer confidence and expectations, wealth effects (house and share prices), and the availability of credit.

Investment (I) — about 15–18%; firms' spending on capital goods. (Note: buying shares is not investment in economics.) Determined by: interest rates, business confidence (Keynes's animal spirits), expected demand and profits, corporation tax, and technological change. It is by far the most volatile component.

Government spending (G) — around 20–25%. Determined by political priorities, the economic cycle (automatic stabilisers) and the fiscal stance.

Net exports (X − M) — determined by the exchange rate, relative inflation rates and competitiveness, and incomes abroad and at home. The UK usually runs a deficit here, so this term is normally negative.

Why does the AD curve slope downwards? A lower price level → higher real wealth (real balance effect) → higher C; lower interest rates → higher I and C; and improved international competitiveness → higher X, lower M.

Your turn — calculate AD

Consumption and saving in more depth

Because C is around 60% of AD, anything that moves it moves the whole economy.

• Keynes's consumption function: C = a + bY, where a is autonomous consumption (spending even at zero income, funded by dissaving) and b is the MPC. The MPC is higher for low-income households — they must spend nearly everything they get. Hence redistribution towards the poor raises AD; and hence targeted support in a recession is more effective than an across-the-board tax cut.
• Wealth effects: rising house and share prices make people feel richer and spend more, even with unchanged income. Falling asset prices work brutally in reverse.
• Confidence and expectations: if households expect redundancy, they cut spending immediately — which helps cause the very recession they feared. Expectations are self-fulfilling.
• Credit availability and interest rates: mortgage-holders are far more sensitive to Bank Rate than outright owners, so the effect of monetary policy depends on the structure of the housing market.

Injection, withdrawal or neither?

Tap an item, then tap where it belongs in the circular flow.

The multiplier effect

An initial injection does not stop when it is first spent. The builder paid £1m to build a school spends part of it in shops; the shopkeeper spends part of that; and so on. The final rise in national income is a multiple of the original injection.

• MPC (marginal propensity to consume) — the fraction of each extra £1 of income spent on domestic output.
• MPW (marginal propensity to withdraw) — the fraction saved, taxed or spent on imports. MPC + MPW = 1.

The multiplier is bigger when leakages are small — a low savings rate, low taxes, few imports. It is smaller in an open economy like the UK with a high MPM. It works in reverse too: a cut in government spending shrinks income by a multiple. And the multiplier is far larger when there is spare capacity (a Keynesian LRAS) than at full employment, where extra AD just raises prices — a point worth writing in any fiscal-policy evaluation.

Your turn — the multiplier from the MPC

Your turn — the multiplier from the leakages

Investment: the volatile component

Investment is spending by firms on capital goods — machinery, buildings, vehicles, software. (Buying shares is not investment in economics; that is saving.) It is only around 15–18% of AD, but it is by far the most volatile component, and it does double duty: it raises AD today and LRAS tomorrow.

• Interest rates — the cost of borrowing, and the opportunity cost of using retained profit. A project is worth doing while its expected rate of return exceeds the interest rate.
• Business confidence — Keynes's animal spirits. Investment is a bet on an unknowable future, so it collapses when confidence goes, however low interest rates are. This is precisely why monetary policy can fail in a slump.
• Expected demand and profits — nobody builds a factory for output they cannot sell. Hence the accelerator.
• Corporation tax and capital allowances; the cost and pace of technological change; and the degree of spare capacity (why invest if your existing machines are idle?).

The UK's chronic weakness: business investment as a share of GDP has long been low by G7 standards — a leading suspect in the UK's dismal productivity growth since 2008. Any question about UK long-run growth or supply-side policy can and should reference it.

What makes the multiplier bigger?

SRAS and the accelerator

Short-run aggregate supply (SRAS) slopes upwards: with money wages and other input prices fixed in the short run, a higher price level raises profit margins, so firms supply more.

SRAS shifts with anything that changes costs of production: wage rates, raw material and energy prices, the exchange rate (a weaker pound makes imported inputs dearer → SRAS shifts left), indirect taxes and subsidies, and productivity. An adverse supply shock (an oil price spike) shifts SRAS left, giving higher prices and lower output — stagflation.

The accelerator: investment depends on the RATE OF CHANGE of national income, not its level. If demand is growing, firms must add capacity; if demand merely stops growing so quickly, investment can fall outright. This makes investment violently pro-cyclical and, together with the multiplier, explains why the economic cycle has such large swings — the multiplier and accelerator feed each other.

Two things students confuse: a movement along AS (caused by a change in the price level) versus a shift of AS (caused by a change in costs or productive capacity). And SRAS shifts with costs; LRAS shifts with the quantity and quality of factors.

Keynesian vs classical LRAS — the central disagreement

LRAS shows the economy's productive capacity — the maximum sustainable output. It shifts right with more or better factors of production: investment in capital, education and training (human capital), net migration and participation, technology, and competition and efficiency-raising reforms. (Notice: those are exactly the supply-side policies of 4.2.5.)

• Classical (monetarist) LRAS is vertical at the full-employment level of output. Markets clear; wages and prices are flexible; the economy always returns to full employment by itself. So an increase in AD raises only the price level in the long run — demand management is useless (or worse, purely inflationary), and the only way to grow is to shift LRAS with supply-side policy.
• Keynesian LRAS is horizontal at low output (deep spare capacity: extra AD raises real output with no inflation), then curves upwards, then becomes vertical at full capacity. So an economy can get stuck in an underemployment equilibrium — because wages are sticky downwards — and government must inject demand to close the gap.

This is the single most important disagreement in macro, and almost every macro policy essay comes back to it. Your evaluation should be: the effect of a demand-side policy depends on where the economy currently sits on the AS curve. Deep recession with spare capacity → a fiscal stimulus raises output. Near full capacity → the same stimulus is mostly inflationary.

AD rises on a vertical LRAS

Fiscal stimulus in a slump

Match the AD component

Tap an example on the left, then the component of AD it belongs to.

An adverse supply shock

Macroeconomic equilibrium and shocks

Macroeconomic equilibrium is where AD = AS, giving the equilibrium price level and real output. Work through any shock in three steps: (1) which curve shifts? (2) which way? (3) what happens to the price level and real output?

• AD shifts right (consumer boom, fiscal stimulus, rate cut, export surge): output rises and the price level rises — by how much depends entirely on where you are on the AS curve. On the flat Keynesian range: big output gain, no inflation. On the vertical range: pure inflation.
• AD shifts left (a confidence collapse, austerity): output falls, price level falls — a recession with a negative output gap.
• SRAS shifts left (an oil shock, a depreciation raising import costs): price level rises, output falls — stagflation, which demand-side policy cannot fix without making one half worse.
• LRAS shifts right (successful supply-side policy, investment, migration, technology): output rises and the price level falls. The only shock with no trade-off.

The one habit that lifts a grade: never assert an effect — always ask where is the economy on its AS curve? The same £20bn stimulus is a triumph in a deep recession and pure inflation at full employment. That conditional reasoning is the whole of AO4 in macro.

The big ideas to know

You have covered the key ideas in AQA 4.2.2. Press Finish to see your score.