Aggregate Demand
ECON 2
Aggregate Demand
• Aggregate demand is the total demand for a
country’s goods and services at a given price
level and in a given time period
• This includes spending by households, firms,
the government and foreigners (who buy
things in or from the UK)
Calculating AD
• Aggregate demand is made up of
– Consumer Expenditure (C) – all spending by
households on consumer products
– Investment (I) – spending on capital goods –
mainly by firms
– Government Spending (G) – spending by central
and local government on goods and services
– Net exports (exports (X) – imports (I)) – the value
of exports (goods and services sold abroad) minus
imports (goods and services bought from abroad)
Calculating AD
• Formula:
AD = C + I + G + (X – M)
• C = £50bn. I = £15bn. G = £25bn. X = £10bn.
M = £15bn.
• Calculate AD
The circular flow of income
• CFI is a model that seeks to explain how the
economy works and how changes in AD occur
The circular flow of income (simple)
Households
Corporations
Government
The circular flow of income
Leakages
Injections
Investment
Exports
Government
Spending
Output
Expenditure
Savings
Income
Taxes
Imports
Activity
Between 2003 and 2006, New Zealand’s trade
balance deteriorated, with imports growing
more rapidly than exports. During this period,
however, the country’s real GDP increased.
1. Are imports an injection or a leakage? Explain
your answer
2. What does the information suggest about the
relationship between I + G and S + T in New
Zealand over the period 2003-06?
The Multiplier
The multiplier is concerned with how national income changes as
a result of a change in an injection, for example investment. The
multiplier was a concept developed by Keynes that said that any
increase in injections into the economy (investment, government
expenditure or exports) would lead to a proportionally bigger
increase in National Income. This is because the extra spending
would have knock-on effects creating in turn even greater
spending.
The size of the multiplier would depend on the level of leakages.
It can be measured by the formula 1/(1-MPC) where the MPC is
the marginal propensity to consume.
The Multiplier Process
• An initial change in aggregate demand can have a much
greater final impact on the level of equilibrium national
income. This is commonly known as the multiplier effect and
it comes about because injections of demand into the circular
flow of income stimulate further rounds of spending – in
other words “one person’s spending is another’s income” –
and this can lead to a much bigger effect on equilibrium
output and employment.
The Multiplier Process
• Consider a £300 million increase in business capital investment
– for example created when an overseas company decides to
build a new production plant in the UK. This will set off a chain
reaction of increases in expenditures. Firms who produce the
capital goods that are purchased will experience an increase in
their incomes and profits. If they in turn, collectively spend
about 3/5 of that additional income, then £180m will be added
to the incomes of others.
• At this point, total income has grown by (£300m + (0.6 x £300m)
– remember to include the original investment!
The Multiplier Process
• The sum will continue to increase as the producers of the
additional goods and services realize an increase in their
incomes, of which they in turn spend 60% on even more
goods and services.
• The increase in total income will then be (£300m + (0.6 x
£300m) + (0.6 x £180m).
• The process can continue indefinitely. But each time, the
additional rise in spending and income is a fraction of the
previous addition to the circular flow.
Multiplier Effects
• Multiplier effects can be seen when new
investment and jobs are attracted into a
particular town, city or region. The final
increase in output and employment can be far
greater than the initial injection of demand
because of the inter-relationships within the
circular flow.
Multiplier effect
Demand for
retail
Demand for
services
Demand for
housing
Building Work
Demand for
public services
Demand for
consumer goods
The Multiplier and Keynesian Economics
• The concept of the multiplier process
became important in the 1930s when
John Maynard Keynes suggested it as a
tool to help governments to achieve full
employment. This macroeconomic
“demand-management approach”,
designed to help overcome a shortage of
business capital investment, measured
the amount of government spending
needed to reach a level of national
income that would prevent
unemployment.
The Multiplier Effect
• The higher is the propensity to consume
domestically produced goods and services, the
greater is the multiplier effect. The
government can influence the size of the
multiplier through changes in direct taxes. For
example, a cut in the basic rate of income tax
will increase the amount of extra income that
can be spent on further goods and services.
The Multiplier Effect
• Another factor affecting the size of the
multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend
money on imports, this demand is not passed
on in the form of extra spending on
domestically produced output. It leaks away
from the circular flow of income and
spending.
The Multiplier Effect
The Multiplier and Capacity
• Multiplier process also requires that there is
sufficient spare capacity in the economy for
extra output to be produced. If short-run
aggregate supply is inelastic, the full multiplier
effect is unlikely to occur, because increases in
AD will lead to higher prices rather than a full
increase in real national output.
• In contrast, when SRAS is perfectly elastic a rise
in aggregate demand causes a large increase in
national output
Differences in the size of the multiplier effect
Differences in the size of the multiplier
effect
AD1 – AD2 is an outward shift of AD
when SRAS is highly elastic. This leads
to a large rise in national output and a
large multiplier effect.
AD3 – AD4 shows a further outward
shift in AD, but where AS is inelastic –
the multiplier effect is smaller because
there is less spare capacity to meet the
increase in demand.
Question 1
• Terminal 5 cost £160 million to build. The
MPC is 0.7. Calculate the effect of this
investment through 3 processes of the
multiplier. Assume there is enough spare
capacity to satisfy any new increases.
Question 2
• Prime Minister W. Steve has announced a
£100bn increase in Government Spending.
• Assume that the first two cycles of increase will
have a MPC of 0.75, falling to 0.685, 0.571 and
0.466 in the 3rd, 4th and 5th increases.
• Calculate the total effect of the multiplier –
round figures to 2dp.
• Comment on reasons why the 3rd, 4th and 5th
increases may have fallen from the initial 0.75
MPC.