How the macroeconomy works.

HookFurlough: the circular flow made visible

ModelThe circular flow: injections v withdrawals

In the simplest model, households supply factors of production to firms and receive income; they spend that income on firms' output, and the loop closes. Real economies leak and refill. Withdrawals take spending out of the loop: saving (S), taxation (T) and spending on imports (M). Injections put spending back in: investment (I), government spending (G) and exports (X). National income is in equilibrium when planned injections equal planned withdrawals; when injections exceed withdrawals, income rises until the extra leakages restore balance, and vice versa. Furlough was G replacing collapsing C at scale.

AQA also expects the distinction between income — a flow, what you earn per period — and wealth — a stock, what you own at a point in time. A pensioner in a mortgage-free £400,000 house with a small pension has high wealth and low income; a young London professional renting on £55,000 is the reverse. The distinction matters because both, separately, drive consumption — which is why house prices keep appearing in AD questions.

ModelAggregate demand: C + I + G + (X − M)

Aggregate demand is total planned spending on an economy's output at each price level. Consumption is the heavyweight — around 60% of UK aggregate demand — and moves with real incomes, interest rates, consumer confidence and wealth: when house prices rise, homeowners feel richer and spend more, the 'wealth effect'. Investment, roughly 15–18% of AD, is the volatile component: it depends on interest rates, expected returns and what Keynes called 'animal spirits' — raw business confidence, which is why investment fell off a cliff in 2009 and again in 2020 while consumption merely sagged. Government spending is set by policy. Net trade depends on the exchange rate, relative UK costs and how fast the rest of the world is growing.

The discipline the examiner checks relentlessly: a change in the price level moves you ALONG the AD curve; a change in any component's determinant SHIFTS it. Falling interest rates shift AD right through at least three letters at once — cheaper borrowing lifts C and I, and the weaker currency that usually follows helps X − M. Spelling out that triple channel is the difference between asserting a shift and analysing one.

ModelThe multiplier: why the first £20bn is not the last

An injection does not raise GDP once; it raises it in rounds. Build a £20bn rail line and the first £20bn becomes contractors' and workers' income; they spend part of it, which becomes shopkeepers' and landlords' income; they spend part of that, and so on. How much survives each round depends on the marginal propensity to consume domestic output — the rest leaks to saving, tax and imports. The multiplier k = 1 ÷ (the sum of the marginal propensities to withdraw), so leakier economies have smaller multipliers.

It cuts both ways: the multiplier amplified the 2008–09 collapse just as surely as it amplifies any stimulus — falling incomes shrank spending, which shrank other incomes. And the UK's multiplier is smaller than students assume, because Britain imports heavily and taxes substantially: most estimates of UK fiscal multipliers sit below 1.5, and the Office for Budget Responsibility has used values well under 1 for some categories of spending. A multiplier of 2.5 in an exam calculation is a teaching device, not a description of Britain.

ModelShort-run aggregate supply: the cost side

SRAS shows the output firms will supply at each price level while input costs are sticky. Anything that changes production costs across the whole economy shifts it: wage rates, raw material and energy prices, import costs via the exchange rate, and business taxes. 2022 was a full-dress rehearsal: after Russia's invasion of Ukraine, UK wholesale gas prices peaked in August 2022 at something like ten times their pre-crisis level, shifting SRAS sharply left — the textbook cost-push shock, with the price level up and real output squeezed simultaneously.

A leftward SRAS shift is the nastiest diagram in macro because it moves both dashboard dials the wrong way at once: inflation rises while output falls. That is why 2022's inflation was so much harder for policymakers than the demand-driven kind — cooling demand fights the inflation but deepens the output loss. When a question mentions energy, wages, or a falling pound raising import costs, SRAS is the curve it wants.

ModelLong-run aggregate supply: the speed limit

LRAS represents productive capacity — the maximum sustainable output when all resources are fully employed. It shifts with the quantity and quality of the factors of production: technological advance, investment in capital, education and skills, the size and mobility of the workforce (including migration), and institutional factors such as planning rules. Britain's defining problem lives here: output per hour grew at roughly 2% a year before 2008 and closer to 0.5% a year since — the 'productivity puzzle' — which is why estimates of UK trend growth have slid from around 2.5% towards 1.5% or below.

AQA accepts both shapes of the curve, and rewards you for choosing deliberately. The classical LRAS is vertical: in the long run output is fixed at capacity and demand only moves prices. The Keynesian LRAS is flat at low output — where spare capacity means demand can expand output without inflation — and turns vertical at full employment. Use the Keynesian curve for recession and stimulus questions, the classical for long-run growth and inflation questions, and never switch shapes mid-answer.

VocabularyKey terms the mark scheme pays for

TrapsMisconceptions that cost marks

ExamWhat examiners want