SAJC 2024 Circular Flow AD AS Lecture Notes Students Print Updated

ST ANDREW’S JUNIOR COLLEGE JC2 H2 ECONOMICS 2024 CIRCULAR FLOW OF INCOME AND AGGREGATE DEMAND & AGGREGATE SUPPLY MODELS In your previous set of lecture notes, Standard of Living and Key Economic Indicators, we looked at how four key indicators are commonly used to measure an economy’s performance. In this set of notes, we will look at the models of the circular flow on income and the Aggregate Demand (AD) and Aggregate Supply (AS). These models help us understand how national income in a country is determined. The AD and AS are very important concepts as they will also be used to analyse economic problems, effects and policies subsequently. Important concepts and tools and analysis  Circular flow of income  Aggregate demand  Determinants of C, I, G and (X-M)  Aggregate Supply  Determinants of Aggregate Supply  National Output  General Price Level  Multiplier Effect Key questions to consider 1. How are households, firms, the government and the foreign sector related to each other in an economy? 2. In the circular flow of income model, why does national output equal to national expenditure? 3. How does national output change when there are changes in households, firms, the government or foreign sector’s behaviour (they buy or produce more or less)? 4. What comprises the Aggregate Demand (AD) and how is AD affected by changes in the determinants of C, I, G and (X– M)? 5. How is Aggregate Supply (AS) affected by its determinants? 6. How does the interaction between AD and AS determine the equilibrium level of national output and general price level? 7. How do changes in the components of AD have a multiplied effect on national income?

St. Andrew’s Junior College Economics Department 2024 2 Contents 1. Circular Flow of Income .......................................................................................................................................................... 3 1.1. The Circular Flow Model (2-Sector Closed Economy) .............................................................................................. 3 1.2. Withdrawals (W) ............................................................................................................................................................ 4 1.2.1. 3 forms of withdrawals: ............................................................................................................................................ 4 1.3. Injections (J) ...................................................................................................................................................................... 5 1.3.1. 3 forms of injections: .................................................................................................................................................. 5 1.4. The Circular Flow Model (Open Economy) ................................................................................................................ 6 1.5. Equilibrium in the Circular Flow of Income and the Four Macroeconomic Objectives ....................................... 8 1.5.1. What happens if injections are not equal to withdrawals? ............................................................................... 8 1.5.2. What is the effect on the four macroeconomic objectives? ............................................................................... 8 2. The Aggregate Demand (AD) / Aggregate Supply (AS) Model ................................................................................. 10 2.1. Aggregate Demand (AD) ............................................................................................................................................ 10 2.1.1. Why does the AD curve slope downwards? ....................................................................................................... 11 2.1.2. Determinants of Aggregate Demand ................................................................................................................... 11 2.2. Aggregate Supply (AS) ............................................................................................................................................... 21 2.2.1. Why is the AS curve shaped like a ‘J’? ................................................................................................................ 22 2.2.2. Determinants of Aggregate Supply ..................................................................................................................... 23 2.3. Usefulness of the AD/AS Model ................................................................................................................................ 26 3. The Equilibrium Level of National Output & General Price Level ................................................................................ 27 3.1. Effects of changes in AS .............................................................................................................................................. 28 3.1.1. Changes in SRAS ...................................................................................................................................................... 28 3.1.2. Changes in LRAS ....................................................................................................................................................... 29 3.2. Effects of changes in AD .............................................................................................................................................. 30 3.2.1. The Multiplier Effect ................................................................................................................................................. 30 3.2.2. What affects the size of the multiplier? ............................................................................................................... 34 3.2.3. What determines the effect of change of national income and general price level? ............................... 35 4. Conclusion ................................................................................................................................................................................ 37

CIRCULAR FLOW OF INCOME AND AGGREGATE DEMAND & AGGREGATE SUPPLY MODELS St. Andrew’s Junior College Economics Department 2024 3 How are households, firms, the government and the foreign sector related to each other in an economy? 1. Circular Flow of Income The circular flow of income is an interactive model that involves households, firms, the government and the foreign sector. The circular flow of income illustrates the flow of money as well as goods and services between producers and consumers in an economy. It is a very useful as a theoretical model for understanding the workings of an economy. It shows how different economic agents (households, firms, government and foreign sectors) are inter-related and how a country arrives at a certain level of national output, expenditure and income. (“Flow” refers to any activity that occurs over time. For example, income is a “flow” concept that occurs per week, per month or per year. Production and consumption too are “flow” concepts.) 1.1. The Circular Flow Model (2-Sector Closed Economy) In its simplest form, the Circular Flow Model comprises only two economic agents, firms and households. Firms and households are linked together through the product market and the resource market. The model explains how income and payment flows between fi rms and households:  Firms are producers of goods and services and also employers of factors of production.  Households are consumers of goods and services and also suppliers of factors of production. Figure 1: 2 Sector Circular Flow of Income (Inner F