Aggregate demand/marginal propensity/multiplier/

What is aggregate demand (AD)?

The total demand for goods and services produced within an economy at a given price level in a given time period.

What is the aggregate demand equation?

AD = C + I + G + (X − M).

What does C represent in the AD equation?

Consumption: household spending on goods and services.

What does I represent in the AD equation?

Investment: spending by firms on capital goods such as machinery and buildings.

What does G represent in the AD equation?

Government expenditure.

What does X represent in the AD equation?

Exports.

What does M represent in the AD equation?

Imports.

What does X − M represent?

Net trade or net exports: export revenue minus import expenditure.

What are the main determinants of consumption?

Disposable income, interest rates, consumer confidence, wealth effects and availability of credit.

How does higher disposable income affect consumption?

Disposable income rises → households have more income available to spend → consumption tends to rise → AD increases.

How do lower interest rates affect consumption?

Borrowing becomes cheaper and saving becomes less rewarding → households borrow more and save less → consumption rises.

How does consumer confidence affect consumption?

Higher confidence about future income and employment makes households more willing to spend and borrow → consumption rises.

How can a wealth effect increase consumption?

An increase in asset values such as house prices makes households feel wealthier → willingness to spend rises → consumption increases.

What are the main determinants of investment?

Interest rates, business confidence and expectations, retained profit and the accelerator effect.

How do lower interest rates affect investment?

Borrowing becomes cheaper → more investment projects become profitable → firms increase investment spending.

How does business confidence affect investment?

Greater confidence about future demand and profits makes firms more willing to invest in capital.

What is the accelerator effect?

The idea that investment responds to the rate of change of demand or output rather than simply its level.

What determines government expenditure?

Fiscal policy decisions, the state of the economy through automatic stabilisers, and political priorities.

What are the main determinants of net trade?

The exchange rate, relative inflation or international competitiveness, and the economic growth rate of trading partners.

How can an appreciation affect net trade?

Exports become relatively more expensive abroad and imports become cheaper → exports may fall and imports rise → net exports decrease.

How can stronger growth in trading partners affect UK AD?

Foreign incomes rise → demand for UK exports may rise → X rises → net exports and UK AD increase.

What is the marginal propensity to consume (MPC)?

The proportion of an additional £1 of income that is spent on consumption.

What is the marginal propensity to save (MPS)?

The proportion of an additional £1 of income that is saved.

What is the marginal propensity to tax (MPT)?

The proportion of an additional £1 of income that is paid in taxation.

What is the marginal propensity to import (MPM)?

The proportion of an additional £1 of income that is spent on imports.

What are leakages or withdrawals from additional income?

Saving, taxation and spending on imports.

What is the multiplier effect?

The process by which an initial change in an injection of spending causes a larger final change in real national income because spending becomes income for others and is partially re-spent.

What is the open-economy multiplier formula?

1 ÷ (MPS + MPT + MPM).

What is the simplified multiplier formula when only MPC is relevant?

1 ÷ (1 − MPC).

Why does a larger MPC create a larger multiplier?

A larger proportion of each additional round of income is re-spent → subsequent rounds of expenditure are larger → the final increase in national income is greater.

Why do higher leakages reduce the multiplier?

More additional income leaves the domestic spending flow through saving, taxation and imports → less is re-spent → subsequent rounds are smaller.

Give the full chain for a fall in interest rates.

Interest rates fall → borrowing becomes cheaper and saving less rewarding → consumption rises → firms find investment finance cheaper so investment rises → C and I rise → AD shifts right → real GDP rises → multiplier may magnify the initial increase.

Interest rates fall — what happens to consumption?

Borrowing becomes cheaper and saving becomes less attractive → household borrowing and spending rise → C rises → AD rises.

Interest rates fall — what happens to investment?

Cost of borrowing falls → more investment projects become profitable → firms increase capital expenditure → I rises → AD rises.

Interest rates fall — what happens to aggregate demand?

C rises and I rises → AD = C + I + G + (X − M) → AD shifts to the right.

Why can the final GDP increase be larger than the initial increase in spending?

The original spending becomes income for other households and firms → some of that income is re-spent → further rounds of expenditure occur → multiplier effect.

What determines the size of the multiplier?

The size of leakages. Lower MPS, MPT and MPM produce a larger multiplier, while larger leakages produce a smaller multiplier.

If the multiplier is 2 and government spending increases by £10 million, what is the eventual increase in national income?

£20 million, assuming the multiplier works as expected.

How should you answer a multiplier calculation question?

State the formula → substitute the figures → calculate the numerical answer → interpret what the multiplier means in a full sentence.