Aggregate demand and the level of economic activity

Question 1

How does aggregate demand (AD) influence the level of economic activity?

Answer 1

AD plays a crucial role in determining the level of economic activity. Higher AD can lead to increased output, employment, and income, while lower AD can reduce these, potentially leading to a recession.

Question 2

What is the multiplier process, and how does it work?

Answer 2

The multiplier process explains how an initial change in spending (e.g., investment or government spending) can lead to a larger overall increase in national income. When an initial expenditure occurs, it increases the income of those receiving it, who then spend part of this income, creating further income and spending cycles, magnifying the overall impact on national income.

Question 3

What is the marginal propensity to consume (MPC), and how is it used to calculate the multiplier?

Answer 3

The MPC is the proportion of additional income that consumers spend on goods and services. The multiplier can be calculated with the formula Multiplier = 1 / (1 - MPC). A higher MPC leads to a larger multiplier, as more income is spent rather than saved, amplifying the effect of initial spending on national income.

Question 4

Why does the size of the marginal propensity to consume (MPC) determine the magnitude of the multiplier effect?

Answer 4

A higher MPC means that a larger portion of any new income is spent rather than saved, which increases the rounds of spending in the economy, leading to a greater multiplier effect. Conversely, a lower MPC reduces the multiplier as less additional income is re-spent.