How the Macroeconomy Works

What the spec says we need to know about...

• The Circular Flow of Income
• Aggregate Demand and Aggregate Supply Analysis
• The Determinants of Aggregate Demand
• Aggregate Demand and the Level of Economic Activity
• Determinants of Short-Run Aggregate Supply
• Determinants of Long-Run Aggregate Supply

The circular flow of income

In simple terms, an economy is made up of firms and housholds.

Firms produce goods and services, and all of these goods and services make up the national output.

The households in a country provide the labour, land an capital that the firms use to produce the national output. The money paid to households by firms for these factors of production is the national income.

Households spend the money they get from the national income on goods and services (outputs) that the firms create- the value of this spending is the national expenditure.

So, all of this creates a circular flow of income, which can be shown by the formula:

National output = National income = National expenditure

An economy's circular flow of income is affected by injections and withdrawals (or leakages).

• Injections into the circular flow of income come in the form of exports, investment and government spending- these go directly to firms
• Withdrawals come in the form of imports, savings and taxes- these withdrawals can be made by households or firms

If injections into the circular flow are greater than withdrawals, this means that expenditure is greater than output- so firms will increase output. As a result national ouput, income and expenditure will all increase.

If withdrawals from the circular flow are greater than injections, this means that output is greater than expenditure- so firms will reduce output. As a result national output, income and expenditure will all decrease.

If injections and withdrawals are equal, then the economy is in equilibrium.

When an injection is made into the circulaer flow of income, the actual change in the national income is much greater than the initial injection- this is called the multiplier effect.

The size of the multiplier effect depends on the rate at which money leaks from the circular flow- e.g. the bigger the leakages, the quicker the money will leave the circular flowand the smaller the multiplier effect will be.

So, if lots of money if being spent on imports, then the multiplier effect will actually be quite small because the the injection will quickly leak out of the circular flow.

Wealth is different to income. Wealth is the total value of all the assets owned by individuals or firms in an economy.

Assets can include actual money, e.g. savings, and physical items, e.g. houses and cars.

Unlike income, which is a flow of money, wealth is a stock concept- you can think of it as a stockpile of resources. These resources aren't currently being used in the circular flow of income, but they could be at some point.

Although income and wealth are different things, there's a correlation between them. E.g. it's likely that an individual with a…