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)
The LRAS curve
- Shows the economy’s potential level of real GDP when all resources are fully employed
- Shows the economy’s full employment level of output
- Economy’s natural level of output and natural rate of unemployment
- It is vertical because it represents the maximum level of output at a particular point in time
- The level of real GDP does not change as the price level changes
- The position is determined by the size of the economy’s work force, the quantity of capital and the state of technology
The SRAS curve
- Shows the impact of an increase in total production (GDP) on the inflation rate
- Curve is upward sloping
- Rising production requires increased resources of labour and capital and this puts pressure on resource prices
- The most important cost of production is the price of labour – wages
- As production in the economy increases, wages begin to rise, and this causes an increase in the general price level
Keynesian range
- The horizontal section of the AS line
- Low levels of national output and supply
- Plenty of unused productive capacity
- In this area, firms would find it very easy to increase their production levels in response to little or no rise the general level of prices
Classical range
- The upper, vertical zone of the AS line
- Generally, no unused productive capacity
- Real national production is at its physical limit because all resources are fully employed
- Even large rises in the general level of prices and the offer of huge profits are not enough for an actual increase in the volume of national production
- This is because firms cannot get hold of the extra resources that they would require to further lift GDP
Intermediate range
- Located at the elbow where the line starts to bend upwards
- Indicated the gradual onset of full employment where the little excess capacity remaining soon gives way to no unused capacity at all
- Moving upwards into this zone, bigger and bigger general price rises are needed to make extra production profitable
Deficient AD – recession
- Low or falling production will cause rising cyclical unemployment and perhaps even a recession
- Living standards would fall, despite lower prices
Excess AD – boom
- Cannot physically produce anymore
- Due to excess spending, production cannot keep up, and the economy overheats
- General shortages of goods and services develop, causing rising prices and demand inflation
- Living standards suffer as a result
Ideal Ad – domestic stability
- Equilibrium would occur near maximum production and employment, but without the problem of rapid inflation in the general level of prices
- Short-term material living standards should be maximized
Favourable supply conditions
- Rise in national output and employment
- Improved economic stability and material living standards
Unfavourable supply conditions
- Rising production costs and falling profits
- Firms may be forced to lift their prices, this accelerating cost inflation
- Cause an unfavourable economic situation called stagflation (simultaneously low GDP growth, high structural unemployment and rapid cost inflation
