A Level Economics Exam Questions by Topic

Using the circular flow of income, explain what happens to a country's national income if planned investment (I) rises while planned savings (S), taxation (T) and imports (M) stay the same at the initial level of income. Then show the same event on an AD/AS diagram.

1. Identify that investment (I) is an injection into the circular flow, adding new spending on top of what households already spend.
2. Since planned injections (I) now exceed planned withdrawals (S + T + M) at the old equilibrium, firms receive more income than is currently leaking out of the flow.
3. This extra spending becomes extra income for households (in wages and profits), some of which is re-spent, so national income rises by a multiple of the initial rise in investment (the multiplier effect).
4. National income keeps rising until a new equilibrium is reached, where the now-higher level of withdrawals (S + T + M rise as income rises, even though the rates are unchanged) again equals injections.
5. On the AD/AS diagram, investment is a component of AD, so a rise in planned investment shifts the AD curve rightward, from AD1 to AD2.
6. At the new intersection with SRAS, both the price level and real output rise; if the economy is instead on the vertical LRAS, only the price level rises in the long run.