The Multiplier and Aggregate Demand/Supply Flashcards
What is the multiplier?
- refers to the proportion by which income will rise following the initial change in spending
- The amount by which real income or GDP changes after an initial change in expenditure
Formula for the multiplier
K (multiplier) = ∆Y/∆I
K=1/(1-MPC) or =1/MPS
(always has a value greater than one)
As the MPC increases, the multiplier increases
- This depends on the attitudes towards spending and saving
- It is an average across all households in the economy
The multiplier process applies to any autonomous change in expenditure
- Could be a change in consumption, investment, government spending or exports
- Applies for any decrease in autonomous spending
E.g. The GFC
2008-09
- Reduced business and household confidence and led to a fall in investment spending in Australia
- This then slowed growth in Australia’s GDP and increased unemployment
What determines the size of the multiplier?
Determined by the factors that affect the marginal propensity to consume
What is aggregate demand?
The total amount of spending in the economy
Aggregate demand curve
- Shows the relationship between the price level and the quantity of real GDP demanded by each of the different sectors: households (C), firms (I), governments and overseas
- Slopes downwards
- Describes a negative or inverse relationship between the level of aggregate demand and the price level
Three ways to explain the inverse relationship (demand curve)
- The income effect
- The interest rate effect
- The open economy effect
Income effect
- As the price level rises, the purchasing power of your income falls and consumption decreases
The interest rate effect
- Inflation effects interest rates
- A rise in the general level of prices means that households and firms demand more funds to finance their transactions
- A rise in the demand for money increases the interest rates, increasing the cost of borrowing, which is a disincentive to spend
- Inflation wrings upward pressure on interest rates, which has a negative impact on investment and consumption spending
Open economy effect
- If the domestic price level (inflation) rises relative to other countries, domestic goods and services become less competitive in those countries, leading to less demand for exports
- Opposite effect if inflation decreases
Inverse relationship in general
Increases in the general level of prices can be expected to reduce total spending in the economy and cause a movement upwards and to the left along the AD curve
Aggregate supply curve
Shows the relationship between the total production of goods and services, and the general price level
Two aggregate supply curves
- Short run aggregate supply curve (SRAS)
- Long run aggregate supply curve (LRAS)