Aggregate Demand Analysis

Question 1

The Aggregate Demand Curve is similar to the normal Demand Curve

Answer 1

1. AD curve uses different axes to the normal demand curve - along the x-axis is national output, and up the y-axis is price level
2. The price level represents the average level of prices in an economy - in the UK this price level is likely to be the Consumer price index
3. AD curve slopes downwards - the lower the price level, the more output is demanded. Lower prices mean consumers can buy more goods/services with their money.
4. A change in the price level will cause a movement along the AD curve - for example, if the price level rose from P to P1, the total AD would fall from Y to Y1
5. A rise in the price level will cause output to fall because:
   - Domestic consumption will be reduced - things become more expensive, so people can purchase fewer goods and services
   - The demand for exports will be reduced - domestically produced products become less competitive
   - The demand for imports will increase - if prices haven’t risen abroad, imports will become cheaper in comparison

Question 2

The AD curve might shift to the right

Answer 2

Aggregate demand can increase or decrease, causing the AD curve to shift right or left.

1. AD curve will shift right if there’s a rise in consumption, investment, government spending or net exports that hasn’t been caused by a change in the price level. E.g:
   - reduction in income tax will => increase in consumers’ disposable income. This tends to => increase in consumption, so there will be an increase in AD and a shift of the AD curve to the right from AD to AD1
   - if government spending changes its fiscal policy and decides to increase its spending above any increase in its revenue, then this is an injection into the cicular flow of income. It will cause an increase in aggregate demand and a shift of the AD curve to the right, e.g. AD to AD1.
   - a weak currency will make exports cheaper and imports more expensive. This will => rise in net exports, so there will be an increase in AD and a shift in the AD curve to the right, e.g. from AD to AD1.
2. Outward shift of curve means that a given price level, more output can be produced - but also, a given amount will have higher price level. For example, if there’s an increase in AD from AD to AD1 - at a price level P, there’s an increase in output from Y to Y1, and at output Y, the price level increases from P to P1.
3. Labour is a derived demand - an increase in AD means output increases, so the demand for labour increases. More jobs are created so that the extra output can be produced, and there will be an increase in employment levels.

Question 3

AD might shift to the left

Answer 3

1. the AD curve will shift to the left if there’s a fall in consumption, investment, government spending or net exports that hasn’t been caused by a change in the price level. For example:
   - A rise in interest rates => reduction in consumer spending because people will choose to save more. Higher interest rates also => reduction in investment because borrowing the money to invest becomes more expensive. Both of these factors => reduction in AD, and a shift of the AD curve to the left, e.g. from AD to AD2.
2. Inward shift of the curve means that at a given price level (P), less output (Y) can be produced - but also, a given amount of output (Y) will have a lower price level (P2). There will also be a decrease in employment levels.

Question 4

The multiplier effect leads to a Larger Increase in aggregate demand

Answer 4

1. When there’s an injection into the economy, the AD curve will shift to the right
2. However, when money is injected into the circular flow of income, the value of the initial injection is multiplied - this is the multiplier effect. One person’s expenditure becomes someone else’s income, so money goes round in circular flow multiple times until it is all leake out.
3. The effect that the AD curve shifts even further to the right - and the bigger the multiplier, the greater the shift
   For example, if a government injects money into health care, the money might be used for wages. Some of this money would then be spent by consumers - increasing consumption. This would create a second increase in AD, and the cycle will continue until all the money from the intial injection is leaked out.
4. The overall size of the multiplier will depend on the size of the leakages from the circular flow of income but its very difficult to measure in practice. Partly due to time lags and the multiplier effect of government spending can take years to fully show up in the economy - e.g. the full benefits to the economy of government spending on improving transport links may only appear years later.
5. Measuring the size of the multiplier is also made difficult because, like everything else in the economy, its changing all the time.
6. This makes it very difficult for any government to accurately control AD

Question 5

Average propensity to Consume or Save shows what happens to incomes

Answer 5

1. Spending and saving are both really important in an economy, and they’re basically opposite processes. Money that’s spent continues to circulate around the economy, while money that’s saved is withdrawn from the circular flow.
2. The average propensity formulas below tell you the proportion of the total national income that’s either spent or saved
   Average propensity to consume (APC) = consumption/ total income = C/Y
   Average propensity to save (APS) = amount saved/ total income = S/Y

Question 6

The marginal propensity to Consume affects the size of the Multiplier

Answer 6

1. In economics, ‘marginal propensity’ is often more important tan ‘average propensity’.
2. The marginal propensity to consume (MPC) is the proportion of any extra income that’s spent on the consumption of goods and services. Similarly, the marginal propensity to save (MPS) is the proportion of extra income thats saved.
   - Marginal propensity to consume (MPC) = change in consumption/ change in income
   - Marginal propensity to save (MPS) = Change in saving/ change in income
3. MPC and MPS are important, since the sixe of the multiplier will depend on how much of an injection of money into the circular flow is spent by those who recieve it, and how much is saved.
4. Money thats saved does not contribute to another person’s income. This means that the more likely people are to spend their money, the greater the multiplier effect
5. So if the MPC is low, the multiplier will be small, because any increase in income will only lead to a small increase in consumption. The rest of the increase in income will be saved.
6. Generally, ppl with lower incomes tent to have higher MPC’s. The MPC also tends to be higher in less developed countries, so the multiplier will be bigger.

Question 7

Learn the formula for calculating the Multiplier from the MPC

Answer 7

There’s a simple formula for working out the multiplier if you know the MPC: -> multiplier = 1/ 1 -MPC
Look at example on page 144

Question 8

The Marginal Propensity to Withdraw can also be used to find the Multiplier

Answer 8

1. There’s also another approach to working out the multiplier. Instead of looking at what proportion of extra income is spent, you can instead look at the proportion of extra income that’s withdrawn from the economy.
2. The extra income can be withdrawn from the economy by:
   (i) being saved,
   (ii) being paid to the government in taxes,
   (iii) being used to import goods from abroad.
3. The marginal propensity to withdraw (MPW) is the proportion of any new income that’s withdrawn from an economy. MPW can be broken down in the following way:
   MPW = MPS + MPT + MPM
   where:
   - MPS = Marginal propensity to save, proportion of any new income that’s saved
   - MPT = Marginal propensity to tax, the proportion of any new income that’s paid as taxes
   - MPM = marginal propensity to import, the proportion of any new income that’s used to import goods

Question 9

Learn the formula fo calculating the Multiplier from the MPW

Answer 9

1. Since extra income must either be spent or withdrawn:
   MPC + MPW = 1
2. This means you can also use the formula below to find the multiplier:
   Multiplier = 1/MPW
   - The multiplier will be relatively big if marginal tax rates are low
   - This is because low marginal tax rates means a small value for MPW, which means that the multiplier is big