Aggregate demand and the level of economic activity Flashcards
What is Aggregate Demand (AD) in the context of economic activity?
Aggregate Demand (AD) is the total demand for goods and services in an economy at a given overall price level and in a given period. It’s represented by the formula: AD = C + I + G + (X - M), where:
C = Consumption by households
I = Investment by firms
G = Government spending
(X - M) = Net exports (exports minus imports)
Why it’s important: AD reflects the total spending in the economy and is a crucial driver of the level of economic activity, influencing output, employment, and inflation.
How does Aggregate Demand (AD) influence the level of economic activity?
Changes in AD directly impact the level of output and employment in an economy:
Increase in AD: Leads to higher output and can reduce unemployment, as firms expand production to meet demand.
Decrease in AD: Reduces economic activity, potentially increasing unemployment and lowering growth.
In exams: Explain how AD influences GDP and unemployment using specific components (like consumer spending increases, or government investment).
Why does an initial change in expenditure lead to a larger impact on local or national income?
An initial injection of spending (e.g., new investment) increases income for workers or suppliers, who then spend part of this additional income, creating further demand. This cycle continues, amplifying the initial injection’s effect on overall income levels due to the multiplier effect.
Key points: Highlight how each “round” of spending becomes additional income for another party, continuing the process until the effects diminish.
What is the multiplier process in economics?
The multiplier process describes how an initial change in spending (such as government investment) causes a more than proportional change in overall national income. This occurs because initial spending generates income for others, leading to further spending cycles.
Formula: Multiplier = 1 / (1 - MPC), where MPC is the marginal propensity to consume.
Use examples, like government infrastructure projects, which increase local employment and, subsequently, consumption.
Define the marginal propensity to consume (MPC) and its role in the multiplier.
The marginal propensity to consume (MPC) is the proportion of any additional income that a consumer spends rather than saves.
Formula for MPC: MPC = ΔC / ΔY, where ΔC is the change in consumption and ΔY is the change in income.
Importance in exams: MPC is crucial in calculating the multiplier, as higher MPC values increase the multiplier’s size, leading to a greater overall impact from initial spending.
How do you calculate the size of the multiplier using MPC?
Multiplier formula: Multiplier = 1 / (1 - MPC).
Example: If MPC = 0.8, then Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5.
In answers: Show how a higher MPC leads to a larger multiplier by allowing more of each additional income to be spent, perpetuating the cycle of income and expenditure.
Why does the size of the marginal propensity to consume determine the multiplier effect’s magnitude?
The larger the MPC, the more income people are likely to spend rather than save. A high MPC results in more rounds of spending and re-spending, increasing the total change in national income from an initial expenditure.
Exam tip: Explain how a low MPC (e.g., if people save more) leads to a smaller multiplier, as less of each income increase is circulated back into the economy.
What factors influence the size of the MPC in an economy?
Income levels: Lower-income individuals tend to have higher MPCs, as they spend a larger proportion of additional income.
Consumer confidence: High confidence can increase MPC as people are more willing to spend.
Interest rates: Low-interest rates encourage spending over saving, potentially raising MPC.
Wealth effects: Rising asset values (e.g., housing) may increase MPC, as people feel wealthier.
What is the importance of the multiplier effect in policy-making?
Governments use the multiplier effect to estimate the impact of fiscal policies. By targeting high-MPC groups or areas, they can amplify the effect of public spending, boosting AD and, therefore, economic growth more effectively.
Example: A government might increase spending during a recession to stimulate demand, expecting the multiplier to create a larger increase in GDP than the initial spending.
What is the Accelerator Effect in economics?
The Accelerator Effect describes the relationship between changes in national income (or output) and the level of investment by firms. Specifically, it suggests that an increase in national income leads to a proportionally larger increase in investment spending by businesses. This is because businesses invest to expand capacity in response to rising demand and output levels.
Formula: Investment = Accelerator Coefficient x Change in National Income
What factors influence the strength of the Accelerator Effect?
The rate of change in GDP: Faster growth in national income leads to stronger accelerator effects, while slower or negative growth weakens it.
Business confidence: High confidence encourages firms to invest more aggressively, amplifying the accelerator effect.
Availability of finance: Access to credit and low-interest rates make it easier for firms to finance new investments.
Existing spare capacity: If firms have excess capacity, they may not need to invest immediately, reducing the accelerator effect.
