AS: H OW THE MACROECONOMY WORKS Aggregate demand and the level of economic activity What happens to a snowball as you continue to roll it?

2.2.4 A GGREGATE DEMAND AND THE LEVEL OF ECONOMIC ACTIVITY  The role of AD in influencing the level of economic activity  The multiplier process and an explanation of why an initial change in expenditure may lead to a larger impact on local or national income  You will not be required to calculate the value of the multiplier using the marginal propensity to consume or the propensities to withdraw  However, you should be able to calculate the value of the multiplier from an initial change in injections and the resulting change in national income

A GGREGATE D EMAND : R ECAP Definition? “The total demand for all goods and services in an economy at any given price level over a period of time” Formula? C + I + G + (X-M) Price Level Real National Output AD P Y Diagram?

A GGREGATE D EMAND & T HE L EVEL OF E CONOMIC A CTIVITY  The higher the level of aggregate demand in an economy, the higher the level of economic activity  A large part of government economic policy is designed to stimulate the various components of aggregate demand  Any increase in C + I + G + (X - M), will shift the aggregate demand curve to the right, and consequently will increase the level of real national output

For each of the following examples, identify whether the impact will be on Consumption, Investment, Government Spending or Net Exports. There could be an increase OR decrease in aggregate demand and more than one component might be affected. ImpactComponent of AD? Increase or Decrease? A cut in the rate of VAT A tax break for new business start-ups A rise in the exchange rate A increase in the main rate of income tax A fall in GDP in the EU A government policy to build more houses An increase in the level of unemployment benefit

A GGREGATE D EMAND & T HE C IRCULAR F LOW OF I NCOME Recap: Which components of aggregate demand have we seen before in the Circular Flow of Income? C + I + G + (X-M) Injection Withdrawal Flow between households and firms, which is impacted by savings and taxes An increase in any of the components of aggregate demand will lead to a rise in the circular flow of income.

T HE M ULTIPLIER (1) The multiplier effect occurs when an initial injection into the economy, or circular flow of income causes a larger final increase in the level of real national income/output. Example:  The government injects £1bn into the education budget to improve teachers’ pay and conditions  This is an injection into the circular flow of income and a component of aggregate demand  We would expect the circular flow of income to rise by £1bn and the overall level of aggregate demand to also rise by £1bn

T HE M ULTIPLIER (2)  However, it is likely that teachers will spend some of that extra £1bn on goods and services  If they spend 80% of the initial injection, then consumption will rise by £800m  This will then stimulate further rounds of capital investment by firms as they seek to meet the new demand, which is a further injection into the circular flow and boost to aggregate demand  Furthermore, firms may decide to take on additional labour to meet this extra demand, thus creating new jobs and new income for workers, which is then spent on consumption in the economy  As a result, the initial £1bn injection into the circular flow has boosted final total aggregate demand by significantly more over the longer term How has the multiplier effect helped the BBC boost the UK economy?

C ALCULATING THE M ULTIPLIER

T HE NEGATIVE M ULTIPLIER  The multiplier effect can also happen in reverse i.e. a withdrawal from the economy  Cuts in spending and increases in taxes will lead to a negative multiplier and a fall in GDP  The size of the multiplier will be dependent on the marginal propensity to consume (MPC).  If individual have a high MPC this will feed through to a higher value of the multiplier.  If individuals have a high marginal propensity to save (MPS) this will lead to a lower value of the multiplier How will cuts in welfare spending impact on the multiplier? Can we learn lessons from the Greeks? To what extent will Government cuts of £12bn impact on the economy by £12bn? How will these cuts impact on GDP?

F ACTORS A FFECTING THE S IZE OF THE M ULTIPLIER  Interest rates  If interest rates are high, then consumption may not rise significantly as additional income may be saved rather than spent  Tax rates  Taxes are a withdrawal from the circular flow, and if tax rates are high then consumers will be deterred from spending or simply have less disposable income with which to consume goods and services  Imports  In the UK, we have a high propensity to consume imports  If we receive increases in disposable income, but this is spent on imported goods, then this would count as a withdrawal from the circular flow of income and national income would not rise as much as anticipated  Spare Capacity  If there is very little spare capacity in the economy, then any increase in aggregate demand may not be able to be met by firms  This is especially true in the short run. As a result, the multiplier effect will be limited and inflation might occur

Read the article on HS2.  What are the likely economic benefits of the project?  How large do you think the multiplier effect might be? Make a list of all the potential beneficiaries of the project.  What issues might limit the size of the multiplier effect for HS2?  HS2 represents a significant injection into the circular flow of income. Does this represent a good use of government spending when considering the potential size of the multiplier compared to other possible projects?

M ULTIPLE C HOICE 1  The relationship between the growth of national income, and the resulting increase in investment is termed the a) accelerator b) output gap c) economic cycle d) multiplier Can you explain your answer?

M ULTIPLE C HOICE 2  Which one of the following combinations is most likely to increase aggregate demand in an economy? Can you explain your answer? CombinationGovernment Spending Taxation Revenue Exchange Rate of the £ AFallingRising B Falling CRising Falling D Rising

M ULTIPLE C HOICE 3  “The multiplier” usually refers to how an initial increase in investment, government spending or exports leads to a larger increase in the level of a) prices b) interest rates c) unemployment d) income Can you explain your answer?

M ULTIPLE C HOICE 4  An increase in Consumption within the UK economy of £10bn has led to an increase in Real National Income of £5bn. What is the value of the multiplier? a) 0.5 b) 1 c) 2 d) 15 Can you explain your answer?