4.10.4 - Aggregate Demand and the Level of Economic Activity

Question 1

What is economic activity?

Answer 1

We shall think of it as centring on the production and consumption of goods in the economy, together with the employment of labour, capital and other inputs that produce output.

Question 2

What is the main link between AD and employment?

Answer 2

When real output increases, firms generally have to employ more workers to produce the additional goods and services that the output increase involves.

Question 3

What is a multiplier?

Answer 3

The relationship between a change in AD and the resulting generally larger change in national income.

Question 4

Give an example of a multiplier?

Answer 4

If a government increases spending by £10 billion, but tax revenue remains unchanged, the resulting budget deficity injected £10 billion of new spending into the circular flow of income.

This spending will increase people’s incomes. If you assume everyone in the economy will save a small fraction and spend the rest, eventually, the £10 billion generates multiple and successively smaller further increases in income, until stages are so small that they can be ignored.

Adding up the successive stages of income, the total increase in income is a multiple of the initial spending increase of £10 billion.

Question 5

Why does the multiplier arise?

Answer 5

One agent’s spending is another agent’s income.

When a spending project creates extra injections of income and demand.

Question 6

What is the equation of the multiplier?

Answer 6

Change in national income / Initial change in government spending

Question 7

What is the marginal propensity to consume?

Answer 7

The fraction of any increase in income which people plan to spend on the consumption of domestically produced goods and services.

Question 8

What is the marginal propensity to save?

Answer 8

The fraction of any increase in income which people plan to save rather than spend.

Question 9

What are the different types of multiplier?

Answer 9

• Government spending multiplier
• Investment multiplier
• Tax multiplier
• Export multiplier
• Import multiplier

Question 10

What are the fiscal policy multipliers?

Answer 10

Government spending and tax multipliers

Question 11

What are foreign trade multipliers?

Answer 11

Export and import multipliers

Question 12

How can the multiplier process work against an economy?

Answer 12

If government spending, consumption, investment or imports fall. Or when taxation or imports increase.

Taxation and imports are withdrawals from the circular flow of income, rather than injections.

Question 13

What are regional multipliers?

Answer 13

Changes in multipliers that lead to changes in regional income.

If a subsidy is used locally, i.e. Cornwall, most of the incomes are spent on goods produced in other areas of the UK / imports.

The regional multiplier, reflecting extra spending within the local area, is likely to be very small.

Question 14

What is the multiplier formula?

Answer 14

k = 1/1-MPC

or

k = 1/MPS

Question 15

What does a high MPC mean in terms of the multiplier effect?

Answer 15

Most new income will be spent on consumption and only a small amount leaks into saving, so the multiplier effect will be bigger.

Question 16

What is the equation of nominal national income?

Answer 16

Nominal national income = Real national income * average price level

Question 17

What is the size of the multiplier dependent on?

Answer 17

Whether nominal national income multiplier or real national income multiplier is being measured.

Question 18

What happens to the mulitplier effect if the SRAS is sloping upwards?

Answer 18

The multiplier effect in real terms will be lower than the multiplier effect in nominal terms because some of the multiplier will deflect into the rising price level.

Question 19

What happens to the multiplier effect if the SRAS is vertical?

Answer 19

The multiplier in real terms would be 0, and the multiplier effect would contribute solely to inflation as real output would not rise.