AS Unit 2 Diagrams
All key diagrams for Pearson Edexcel IAL AS Economics Unit 2 (WEC12/01) — AD/AS model, multiplier, Phillips curve, policy diagrams and more.
2.3.2 / 2.3.3 — AD/AS Model
2.1Aggregate Demand Curve — Shift vs Movement
AD slopes downward for three reasons:
- Real balance effect: Higher price level reduces real value of money → wealth falls → consumption falls
- Interest rate effect: Higher prices → higher demand for money → interest rates rise → I and C fall
- International competitiveness: Higher domestic prices → exports less competitive → X falls, M rises → net exports fall
Always identify WHICH component of AD is affected. "Government spending increases → G rises → AD shifts right" is more precise than just "AD increases."
2.2Short-Run & Long-Run Aggregate Supply
SRAS (upward sloping): As prices rise, firms produce more. Shifts when input costs change:
- SRAS shifts RIGHT: ↓ wage costs, ↓ oil price, ↓ raw material costs, improved technology
- SRAS shifts LEFT: ↑ wages, ↑ oil price, negative supply shock (COVID, war)
- More capital (investment), better technology, improved education/skills, immigration
- A rightward LRAS shift = long-run economic growth
LRAS is vertical because in the long run, all wages and prices are fully flexible. The position of LRAS determines potential GDP. Short-run fluctuations are around this trend.
2.3Full AD/AS Model — Equilibrium, Demand-Pull Inflation & Recessionary Gap
Panel 1 — Full employment equilibrium: AD intersects SRAS at Yf (on LRAS). Price level P*, full employment, no output gap.
Panel 2 — Demand-pull inflation: AD₁→AD₂ (e.g. tax cuts, rising consumer confidence). Equilibrium moves beyond Yf → inflationary gap. Price rises from P₁ to P₂, output temporarily rises above Yf. Long run: SRAS shifts left as wages rise → price rises further, output returns to Yf at higher P.
Panel 3 — Recessionary gap: AD₁→AD₀ (e.g. financial crisis, falling business investment). Output below Yf at Y₀ → negative output gap → unemployment. Long run: wages fall → SRAS shifts right → recovery to Yf at lower price.
Panel 2 — Demand-pull inflation: AD₁→AD₂ (e.g. tax cuts, rising consumer confidence). Equilibrium moves beyond Yf → inflationary gap. Price rises from P₁ to P₂, output temporarily rises above Yf. Long run: SRAS shifts left as wages rise → price rises further, output returns to Yf at higher P.
Panel 3 — Recessionary gap: AD₁→AD₀ (e.g. financial crisis, falling business investment). Output below Yf at Y₀ → negative output gap → unemployment. Long run: wages fall → SRAS shifts right → recovery to Yf at lower price.
Always show three curves: AD, SRAS, and LRAS. Shade the output gap and label it. For policy questions, show the AD or SRAS shift and explain which policy instrument was used.
2.4Keynesian vs Monetarist/Classical LRAS
Keynesian view: Three zones depending on how close to full capacity: (1) Horizontal — high unemployment, spare capacity, AD boost raises output without raising prices. (2) Upward sloping — near capacity, AD boost raises both output and price. (3) Vertical at Yf — fully employed, any AD boost is purely inflationary.
Monetarist/Classical view: The LRAS is always vertical at Yf. AD only determines the price level in the long run. Fiscal stimulus is ineffective — only raises price. Supply-side policies are needed to shift LRAS right.
Monetarist/Classical view: The LRAS is always vertical at Yf. AD only determines the price level in the long run. Fiscal stimulus is ineffective — only raises price. Supply-side policies are needed to shift LRAS right.
This is a major ideological debate. Keynesian = governments should intervene with fiscal policy. Monetarist = markets self-correct, only control money supply. Essays on macroeconomic policy often need both views.
2.3.4 / 2.3.5 — National Income & Growth
2.5Circular Flow of Income
Inner flow: Factor incomes (wages, rent, interest, profit) flow from firms to households; consumer spending flows back from households to firms.
Leakages (W): S (savings into financial sector) + T (taxes to government) + M (import spending abroad)
Injections (J): I (investment from firms) + G (government spending) + X (export revenue)
Leakages (W): S (savings into financial sector) + T (taxes to government) + M (import spending abroad)
Injections (J): I (investment from firms) + G (government spending) + X (export revenue)
- If J > W: national income rises (expansion)
- If W > J: national income falls (contraction)
- Equilibrium: J = W → national income stable
The equilibrium condition J = W (or I+G+X = S+T+M) is different from Y = AD. Both can be tested. The multiplier works through the circular flow — an injection circulates multiple times.
2.6The Keynesian Multiplier
The multiplier (k): An initial injection (e.g. ΔG = £10bn) leads to a larger final rise in national income (ΔY > ΔG).
- Mechanism: Government spends → workers earn wages → they spend on other goods → those workers earn → round 2 spending etc.
- MPC = 0.8 → k = 1/(1−0.8) = 5 → £10bn injection → £50bn rise in income
- Open economy: k = 1/(MPS+MPT+MPM) — smaller multiplier when more leakages
- The multiplier effect is larger when MPC is high (people spend rather than save)
- Keynesian argument for fiscal stimulus — injection has amplified effect on output
Always calculate k and ΔY in a numerical question. E.g. "If MPC=0.75, k = 1/0.25 = 4. A £5bn rise in G → national income rises by £20bn." State the multiplier effect clearly.
2.3.6 — Policy Diagrams
2.7Phillips Curve — Short Run vs Long Run
Short-run Phillips Curve (SRPC): Inverse relationship — lower unemployment associated with higher inflation. Government can "trade off" between the two.
- A → B: Expansionary policy lowers unemployment below NAIRU, inflation rises
- B → C: Workers demand higher wages as inflation expectations rise → SRPC shifts up to SRPC₂
- Long-run: At NAIRU, there is no trade-off. Any attempt to hold unemployment below NAIRU leads to accelerating inflation (Friedman's expectations-augmented PC)
- NAIRU = Non-Accelerating Inflation Rate of Unemployment
The breakdown of the SRPC in the 1970s (stagflation — high unemployment AND high inflation simultaneously) undermined Keynesian demand management. It's a key evaluation point against expansionary fiscal policy.
2.8Fiscal Policy — Expansionary & Contractionary
Expansionary fiscal policy (recession → full employment): ↑ G or ↓ T → AD shifts right (AD_rec → AD₁). Closes recessionary gap, raises output and employment. Risk: inflation if overshoots Yf.
Contractionary fiscal policy (overheating → target): ↓ G or ↑ T → AD shifts left. Closes inflationary gap, reduces inflation. Risk: lower growth, higher unemployment.
Contractionary fiscal policy (overheating → target): ↓ G or ↑ T → AD shifts left. Closes inflationary gap, reduces inflation. Risk: lower growth, higher unemployment.
Evaluation of fiscal policy: time lags (recognition lag, implementation lag, effect lag), crowding out (G↑ → government borrows → interest rates rise → private investment falls), and the size of the multiplier all affect effectiveness.