In previous articles, Zenith has introduced you to the theme of Scarcity: The Central Economic Problem and other key concepts in Microeconomics. We strongly recommend that you refer to these articles if you are feeling uncertain about important concepts such as Demand and Supply, Price Elasticity, or types of Government Intervention in Economic Markets. Access these articles on the A Level Economics syllabus at the following links:
Theme 1.1: Scarcity as the Central Economic Problem
Themes 2.1.1. and 2.1.2: Price Mechanisms, Demand and Supply
Theme 2.1.3: Price Elasticity and Government Intervention
Moving on from Microeconomics, Zenith, Singapore’s top Economics tuition centre, will be broaching Theme 3.1: Introduction to Macroeconomics in this article. While Microeconomics focuses on the decisions of individual economic actors (e.g. a particular company, a household, an individual), Macroeconomics is concerned with entire countries and industries (e.g. all fashion brands, instead of only H&M or Nike). Macroeconomics is important because it provides us with an overview of the state of the entire economy. Whether the economy is doing well has a direct impact on whether its various economic actors are able to satisfy their unlimited desires with limited resources. This is tied to Scarcity, the Central Economic Problem, which explains that an economy that is able to produce a larger amount of goods to satisfy unlimited wants benefits its consumers more, ceteris paribus.
While this article is designed to cater to both H1 and H2 A Level Economics students, it is important to note that there are some differences in the concepts students are required to be familiar with.
H1 A Level Economics students can refer to Fig 1. to browse through the concepts that they need to know for Theme 3.1, and H2 students can refer to Fig 2. The additional concepts and tools for analysis required by the H2 syllabus are annotated in Fig 2. Throughout this article, Zenith has indicated the sections which are applicable to H2 students only.
Fig 1. H1 A Level Economics syllabus for Theme 3.1
Fig 2. H2 A Level Economics syllabus for Theme 3.1
Circular Flow of Income (H2 only)
The circular flow of income illustrates for us the interdependent relationship between 4 economic actors––households, (local) firms, the government and foreign traders. This relationship is characterised by the constant exchange of goods, services and money between the 4 parties involved. Take for example that all households have $500 in total. They spend the money on firms, which distribute the $500 as income to their employees. These employees are part of households, who spend the $500 they receive again, creating a cycle of expenditure and earning. Households, through their expenditure, contribute money to producers, enabling them to pay for the factors of production (FOP) and produce the desired goods, which the households pay for in a continuous cycle. This characterises the relationship between households and local firms. When households decide to put aside some of their money as savings, denoted as S, the level of income in the circular flow of income decreases as money is withdrawn from it. The opposite occurs when households decide to withdraw their savings for expenditure (an injection into the circular flow of the economy).
The government enters into this relationship as they are similarly able to spend. For example, they need to spend money on raw materials and labour to build governmental infrastructure like roads and street lights. This is called government expenditure and is denoted as G in the study of Macroeconomics. Such additions of money into the circular flow of income are called injections and increase the level of income in the entire economy. Governments, unlike firms, are also able to tax households and firms. Taxes, denoted as T, are withdrawals from the circular flow of income as they reduce the level of income in the circular flow.
Economies that participate in international trade are described as open economies. They are affected by the expenditures and earnings from goods and services abroad. Foreign traders influence the circular flow of income of a particular country through import expenditure, denoted as M, and export revenue, denoted as X. Import expenditures are withdrawals because money from the local economy is contributed to the economies of other countries when goods and services from international economies are consumed. Export revenue, on the other hand, is a form of injection into the economy as consumers from overseas are contributing to the domestic economy by consuming local goods and services.
The above relationship can be easily summarised in the following diagram (Fig 3) which H2 A Level Economics students are required to know how to sketch during their examinations.
Fig 3. Sketch of the Circular Flow of Income
Aggregate Demand (AD) and Aggregate Supply (AS)
Before diving into the concepts of Aggregate Demand (AD) and Aggregate Supply (AS), the A Level Economics syllabus also expects you to understand what the General Price Level (GPL) of an economy is. The General Price Level is defined as the average of current market prices of all goods and services produced within an economy. It is a key indicator of how a particular economy is performing. An increasing GPL is a reflection of either increasing demand or inflation. Inflation refers to the increase of the price of goods and services which causes the value of a currency to drop. Take for instance that $1000 in Singapore Dollars (SGD) used to be worth one iPhone. The value of the $1000 in SGD falls if it is no longer able to purchase one iPhone and a consumer now needs, for example, $1500 to purchase the same iPhone. Correspondingly, a decreasing GPL is a reflection of either decreasing demand or deflation. Deflation refers to the drop in the price of goods and services, which, while on the surface, might seem to benefit consumers as they are now able to consume more goods with the same amount of money, it has detrimental impacts on the economy in the long run. This is as deflation marks a contraction of the entire economy which will impact all economic actors eventually. Companies may even choose to respond to falling prices by slowing down their production, which leads to layoffs and salary reductions, thus, deflation is often a sign of a weakening economy.
The Real National Income (RNI), which will also affect your understanding of AD and AS, is defined as the value of national income (Y), with the effects of inflation removed. This means that an increase in RNI indicates that output has increased in terms of quantity, with prices being constant. This means that the GPL remains constant as RNI increases.
Aggregate Demand
Aggregate Demand (AD) is defined as the total demand of households (who consume), firms (who produce), the government, and foreign traders. Referring to Fig 3. above, which outlines how the 4-sector open economy functions, the AD = expenditure (from households + the government) + investments + (export revenue - import expenditure).
In Economics notations:
Expenditure by consumers = C
Investments = I
Government expenditure = G
Export revenue = X
Import Expenditure = M
Therefore, AD = C + I + G + (X - M).
Fig 4. AD Graph
As shown in the above graph in Fig 5., as GPL decreases, RNI increases. The GPL of goods has an inverse relationship with RNI as the purchasing power of money (i.e. the value of a currency) falls as the GPL increases. Fewer goods and services are purchased due to this weakening of purchasing power, resulting in a downward slope in the RNI, which represents the output of the economy. This concept is similar to that of Supply and Demand in Microeconomics. The way the market functions is similar to the way individual economic actors make decisions, as the market itself is made up of individuals.
Aggregate Supply
Aggregate Supply (AS) is defined as the total output of goods and services that domestic firms want and are able to produce and sell at each GPL for a given period of time.
The AS graph is different from how the Supply graph looks like in Microeconomics. It is broken up into three “ranges”, as seen in Fig 5., which are distinct segments indicative of various market phenomena.
Fig 5. AS Graph
Excess Capacity: The AS has an excess capacity when it is a horizontal line. This is up to where the RNI is at C. When the AS is in this range, there is a significant amount of excess capacity. This means that there is no lack of the factors of production required by producers to meet the demand for a particular good or service. The GPL is stable because there is no need for the producers to compete for resources required in production, which typically results in an increase in price caused by insufficient supply to meet demand.
Limited Spare Capacity: The AS still has some excess capacity, but less than when the AS graph is a horizontal line. Production is increasing, as indicated by the upward curve and the increment of the RNI from C to D. This causes a rise in the GPL as firms now have to compete for resources as they become increasingly scarce. They might also have to turn to less efficient resources and modes of production, resulting in a rise in the unit costs of production.
No Spare Capacity: The AS becomes a vertical line when there is no longer any excess capacity left, which means that all producers are using all the factors of production available and are at maximum output. As supply can no longer increase to meet increasing demand, the only thing that can happen at this point is for the GPL to rise. This corresponds with the concept in Microeconomics of Supply and Demand, where insufficient supply to meet demand causes an increase in price.
Multiplier Effect (H2 Only)
Lastly, for A Level candidates who are sitting for the H2 Economics examinations, it is imperative to understand how the multiplier effect works. There are 8 mark to 10 mark questions which demand a clear explanation of the multiplier effect in relation to the circular flow of income.
The multiplier effect, in sum, is simply defined as the number of times RNI expands as a result of an initial injection into the circular flow of income.
Every economic actor has a different marginal propensity to consume (MPC). This refers to the proportion of additional income that is spent on consumption. If a household has an MPC of 0.4, this means that for every additional dollar of income earned, 40 cents is spent on consumption, regardless of current income levels.
MPC influences how the multiplier effect works. Take for instance that $500 is injected into the circular flow of an economy from export revenue. The process of earning does not stop here as the receivers of the $500 have an MPC. Let’s assume for this example that their MPC is 0.4. This means that they will spend $200 of the $500 earned, saving the rest. The $200 is thus received by another group of people, who also have an MPC. If their MPC is also 0.4, they will spend $80 of the $200, saving the rest. This process continues, with each new round of spending being 40% of the previous round, assuming that every receiver of the money has an MPC of 0.4. It stops when the additions to the savings reach a total of $500, returning the economy to its equilibrium as savings = investments once again. By this time, the economy would have expanded by 1.6667 times as 1/0.6 (the marginal propensity to save) is 1.6667. To find out how the multiplier effect works in greater Mathematical detail, you can refer to the following website, a multiplier effect calculator (Zenith is in no way affiliated to the site!).
To sum up, Zenith, as Singapore’s top Economics tuition center, has covered the following concepts in this article:
Circular Flow of Income (H2 Only)
4-sector open economy diagram
Aggregate Demand and Aggregate Supply
General Price Level
Real National Income
The Multiplier Effect (H2 Only)
A Level Economics can be daunting for many as they have not approached the subject prior to entering Junior College, however, it can be a fun and fulfilling journey! Our tutors, in addition to having a wealth of experience, are all passionate, young, and fun individuals who believe in making lessons genuinely engaging and relatable for the Zenith family! Find out more about our meticulously curated A Level Economics tuition programme here and sign up for a free trial lesson today. We look forward to seeing you in class (and maybe a few of your friends too)!