2.4 Aggregate Demand And The Level of Economic Activity

Question 1

What is the role of AD in influencing the level of economic activity?

Answer 1

• The factors which influence the level of economic activity are:
• Employment: influences production and consumption
• Confidence: influences the level of spending and investment
• Events: natural disasters or Christmas influence the level of consumer spending
• Other factors: such as taxes and interest rates influence how much firms and
  consumers borrow, save or spend.

Question 2

What is the multiplier effect?

Answer 2

• The multiplier effect occurs when there is new demand in an economy.
• This leads to an injection of more income into the circular flow of income, which leads to economic growth.
• This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created.
• The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income.
• It occurs since ‘one person’s spending is another person’s income’.

Question 3

What is the multiplier ratio?

Answer 3

• the ratio of the rise national income to the initial rise in AD.
• In other words, it is the number of times a rise in national income is larger than the rise in the initial injection of AD, which led to the rise in national income.

Question 4

What is the significance of the multiplier to shifts in AD?

Answer 4

• If an economy has a lot of spare capacity, extra output can be produced quickly and at little extra cost.
  -This makes SRAS elastic and it means the size of the multiplier will be larger.
• A small increase in AD will lead to a large increase in national income

Question 5

What is the significance of the multiplier to shifts in AD if SRAS is inelastic?

Answer 5

• If SRAS is inelastic, the multiplier effect is likely to be smaller than its potential.
• This is because if AD increases, prices will increase rather than a full increase in national income.
  -This higher rate of inflation will lead to higher interest rates.
  -This will
  discourage spending and borrowing, and it will encourage saving, since the reward for saving is higher.

Question 6

What is a reverse multiplier?

Answer 6

• It is also possible to have a ‘reverse’ multiplier.
• This means that a withdrawal of income form the circular flow of income could lead to an even larger decrease in income for the economy.
• This could decrease economic growth and potentially lead to a decline in the economy.

Question 7

What is the marginal propensity to consume and how does it help to calculate the size of the multiplier?

Answer 7

• A consumer’s marginal propensity to consume is how much a consumer changes their spending following a change in income.
• The higher the MPC, the bigger the size of the multiplier.
• The government could influence the MPC by changing the rate of direct tax.
• If
  consumers have more disposable income due to lower income tax rates, their
  propensity to consume might increase.

Question 8

What is the marginal propensity to save and how does it help to calculate the size of the multiplier?

Answer 8

• A consumer’s marginal propensity to save plus the marginal propensity to
  consume is equal to 1.
• If consumers save more than they spend, the size of the multiplier will be
  small.

Question 9

How do we calculate the multiplier?

Answer 9

• One formula that can be used to calculate the multiplier is 1/(1-MPC).
• Example:
• If consumers spend 0.6 of every £1 they earn, they save 0/4. Therefore, the
  multiplier will be:

1/(1-0.6) = 1/0.4 = 2.5.

-This means that every £1 of income generates £2.50 of new income.