The circular flow of income

Households supply factors of production to firms and receive income; they spend it on firms' output. Income flows round in a circle. Two things can happen to that flow:

• Leakages (withdrawals, W) — income that leaves the circular flow: Savings + Taxation + iMports.
• Injections (J) — spending that enters from outside: Investment + Government spending + eXports.

National income can be measured three ways, which must be equal: the output method (the value added of all firms), the income method (all wages, rent, interest and profit) and the expenditure method (C + I + G + X − M). One person's spending is another's income is the value of what was made.

Measurement caveats: GDP misses the informal (shadow) economy and unpaid household work, says nothing about distribution, ignores externalities and resource depletion, and takes no account of leisure or wellbeing. It is a measure of activity, not welfare.

Aggregate demand

Aggregate demand is total planned spending on domestic output at each price level.

The AD curve slopes downward, but not for the microeconomic reasons:

• Real balance / wealth effect — a lower price level raises the real value of money holdings, so people can buy more.
• Interest rate effect — a lower price level reduces the demand for money, lowering interest rates, raising I and C.
• International trade effect — a lower domestic price level makes exports more competitive and imports dearer, raising (X − M).

What shifts each component:

• C (~60% of UK AD) — disposable income, consumer confidence, interest rates (cost of borrowing, reward for saving), wealth (house and share prices), the availability of credit, taxation. The relationship between income and consumption is the consumption function: as income rises, C rises but by less (the MPC is below 1), so the average propensity to consume falls.
• I (~17%) — interest rates, business confidence / "animal spirits", expected demand, corporate profits, technology, corporation tax, spare capacity. The most volatile component — it is the swings in I that drive the economic cycle.
• G (~20%) — a policy choice, plus automatic stabilisers. (Note: transfer payments like pensions and benefits are NOT part of G — they are not payment for output; they appear later as C.)
• X − M — the exchange rate, world income, relative inflation rates, non-price competitiveness, protectionism.

The role of expectations is decisive. If firms expect a recession they cut investment; that cut causes the recession. Keynes's "animal spirits" are not a footnote to macro — they are why AD can collapse without any change in the underlying fundamentals.

Your turn — calculate AD

What shifts AD?

Aggregate supply: SRAS and LRAS

Aggregate supply is total planned output at each price level.

Short-run AS (SRAS) slopes upward: in the short run money wages and input prices are sticky, so a higher price level raises profit margins and firms expand output. SRAS shifts with anything that changes firms' costs: wage rates, raw material and oil prices, the exchange rate (a weaker pound raises import costs → SRAS left), indirect taxes and subsidies, and productivity.

Long-run AS (LRAS) shows the economy's productive potential — what it can produce when all its factors are fully employed. It is the AD/AS equivalent of the PPC. LRAS shifts only with the quantity or quality of the factors of production: the size and skill of the labour force (education, training, migration), the capital stock (net investment), technology, enterprise, natural resources, and economic incentives/efficiency (supply-side reform).

Two views of the shape of LRAS — and this is where the great macro divide sits:

• Classical / neo-classical: 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, inflationary). Only supply-side policy can raise output.
• Keynesian: LRAS is L-shaped. When there is mass unemployment and spare capacity, the curve is horizontal — output can rise with no inflation at all. As the economy nears capacity the curve curves upward (bottlenecks appear), and at full capacity it becomes vertical. So the economy can get stuck below full employment, and government must raise AD to close the gap. "In the long run we are all dead."

Everything depends on where AD cuts AS. A fiscal stimulus in a deep recession (on the flat Keynesian range) raises real output with little inflation. The same stimulus at full capacity (on the vertical range) raises only prices. That single insight answers a huge share of A-level essay questions.

SRAS or LRAS?

The classical view

Macroeconomic equilibrium and output gaps

Macroeconomic equilibrium is where AD = AS: it determines the price level and real GDP together. Trace shocks through it:

• AD rises (consumer boom, fiscal stimulus, weaker pound) → real GDP up, price level up → demand-pull inflation. How much of each depends on where you are on AS.
• SRAS falls (an oil shock, a currency collapse raising import costs) → price level up, real GDP down → cost-push inflation and stagflation — the nastiest combination, because fixing one worsens the other.
• LRAS rises (successful supply-side policy) → real GDP up, price level down — non-inflationary growth, the policy holy grail.

Output gaps measure where actual output sits relative to potential output (trend/LRAS):

• Negative output gap — actual output is below potential. Spare capacity, high cyclical unemployment, downward pressure on inflation. On a PPC: a point inside the curve.
• Positive output gap — actual output is above the sustainable trend. Overheating, labour shortages, rising inflation. It is unsustainable — you can run a factory flat out for a while, not forever.

Why this is hard in practice: potential output cannot be observed. The Bank of England and OBR must estimate the output gap in real time, and they are often revised heavily afterwards. Setting policy from a mismeasured output gap is a leading cause of policy error — a form of government failure.

Your turn — the output gap

Your turn — real vs nominal

Stagflation

Where does AD cut AS?

Investment

AD, SRAS or LRAS?

Tap a card, then tap the curve it shifts.

Match each AD component to its description

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered aggregate demand and aggregate supply from the OCR A-level Economics (H460) specification. Press Finish to see your score.