3.2.2.4 AGGREGATE DEMAND AND THE LEVEL OF ECONOMIC ACTIVITY

Define economic activity

Any action that involves the production, distribution, and consumption of goods and services in an economy

The greater the shift in AD, the greater the shift in what?

The greater the change in real output

The extent to which real output changes, depends on what?

The steepness of the AS curve

Define multiplier

The process by which an initial change in spending leads to an overall change in national income (GDP)

Where is the multiplier in this image below?

Where is the multiplier in this image?

• the action is somewhere between AD1 and AD2, but the multiplier is between AD2 and AD3

What is one multiplier equation?

Change in national income/ initial change in government spending

What is the other multiplier equation?

Change in Y/Change in G

Define marginal propensity to consume?

The fraction of any increase in income which people plan to spend on the consumption of domestically produced goods and services

Define marginal propensity to save?

The fraction of any increase in income which people plan to save rather than spend

What is the multiplier formula?

K = 1/(1-MPC)

What does MPC mean?

Marginal propensity to consume

If the MPC is 0.2, what is the MPS?

0.8

What does a postive multiplier mean?

An outwards shift in AD

Eg. more spending, increased GDP

What does a negative multiplier mean?

An inwards shift in AD

Eg. a contraction in the economy (less government spending)

What is the name for when the government cuts spending on public services (schools, hospitals)

Fiscal austerity

What is the approach called that links the multiplier effect to John Maynard Keynes?

"Demand management approach" - designed to help overcome a shortage of capital investment measured by the amount of government spending needed to reach a level of national income that would prevent unemployment

What are 5 things that determine the value of the multiplier?

• propensity to import

• propensity to save

• propensity to tax

• amount of spare capacity

• avoiding crowding out

Explain "propensity to import"?

If people save more of their income

Less spending

Smaller multiplier

Explain "amount of spare capacity"?

If the economy has lots of spare capacity

Extra spending can expand outfit easily

Large multiplier

Explain "avoiding crowding out"?

If government spending pushes up interest rates

Private investment may fall

Crowding out

Multiplier becomes smaller

What does "crowding out" mean?

Where increased government spending or lower taxes can lead to a rise in government borrowing and or inflation which causes interest rates to rise and has the effect of slowing down economic activity

Define the multiplier effect

An initial change in aggregate demand can have a much greater impact on the level of equilibrium national income

When will the multiplier effect be large? (5)

• the propensity to spend extra income on domestic goods and services is high

• the margins rate of tax on extra income is low

• the propensity to spend extra income rather than save is high

• consumer confidence is higher

• the businesses in the economy may have the capacity to expand production to meet increases in demand

What does the size of the multiplier effect on?

How much of any extra income is spent rather than withdrawn from the circular flow

What is a key evaluation/drawback of the multiplier effect?

• time lags

Even if the initial action (multiplier) is large, the actual impact on nations income may take months or years to come into full effect

Further evaluation of the multiplier effect?

• households spending repose takes time

• firms respond slowly to rising demand

• policy implementation delays

• multiplier weakens overtime

Explain how the elasticity of SRAS affects the size of the multiplier?

When SRAS is elastic, larger multiplier

elastic - output rises more than prices

When SRAS is inelastic, smaller multiplier

inelastic - prices rises more than output

Define nominal national income

The total value of all gods and services produced in an economy, measured using current prices

• does not include inflation

Define real national income

The value of all goods and services produced

• adjusted/including inflation

• measured using constant prices (a base year - set to 100)

Define accelerator?

A change in the level of investment in new capital goods induced by a change in nations income or output

The size of the accelerator depend on the economy capital - output ratio

Summarize the accelerator theory?

The accelerator theory states that investment depends on the rate of change of output or demand

Example of the accelerator theory?

• when demand or national income rises

• firms need more capital - to produce more output

• this leads to higher investment

Smaller changes in demand can cause large savings in investment

What does MPT and MPM mean?

• marginal propensity to tax

• marginal propensity to import

If there is no government, and a closed economy, which one do you focus on?

(MPS + MPT + MPM)?

Marginal propensity to save

What does a closed economy mean?

Where there is no imports and exports