Understanding aggregate demand and the AD curve

Aggregate demand (AD) represents the total spending on goods and services within an economy over a specific period. The AD curve illustrates this relationship, showing how changes in the overall price level affect the quantity of output demanded.

Features of the AD curve

• Axes of the curve - The x-axis shows national output, and the y-axis represents the price level, which is the average cost of goods and services, often measured by the Consumer Price Index (CPI).
• Downward slope - The curve slopes downwards from left to right, indicating that a lower price level leads to higher demand for output. This occurs because reduced prices increase purchasing power, allowing consumers to buy more.

Movements along the AD curve

A change in the price level results in a movement along the AD curve. For example, if the price level rises, aggregate demand decreases, leading to lower output.

Reasons for reduced output when price level increases:

• Lower domestic consumption - Higher prices make goods and services more expensive, reducing what consumers can afford.
• Decreased export demand - Domestically produced items become less competitive abroad as their relative prices increase.
• Increased import demand - If foreign prices remain stable, imports appear cheaper, shifting demand away from local products.

Factors causing shifts in the AD curve

Shifts in the AD curve occur when aggregate demand changes due to factors other than the price level, moving the entire curve left or right.

Causes of a rightward shift in the AD curve

A rightward shift increases aggregate demand, allowing more output at the same price level or a higher price level for the same output. This also boosts employment as firms demand more labour to meet higher production needs.

Key factors include:

• Rise in consumption - For instance, a cut in income tax boosts disposable income, encouraging more spending.
• Increase in investment - Lower interest rates or improved business confidence encourages more business investment.
• Higher government spending - When spending exceeds revenue, it injects money into the economy.
• Growth in net exports - A weaker domestic currency makes exports cheaper and imports more expensive, improving the trade balance.

Causes of a leftward shift in the AD curve

A leftward shift decreases aggregate demand, resulting in less output at the same price level and reduced employment levels.

Key factors include:

• Fall in consumption - Rising interest rates encourage saving over spending.
• Decrease in investment - Higher interest rates raise borrowing costs, deterring business expansion.
• Lower government spending - Reduced public expenditure withdraws money from the economy.
• Decline in net exports - A stronger domestic currency makes exports more expensive and imports cheaper, worsening the trade balance.

The multiplier effect and its process

The multiplier effect occurs when an initial injection of spending into the economy leads to a larger overall increase in national income. This happens as the injected money circulates, creating further rounds of expenditure.

How the multiplier process works

Money spent by one party becomes income for another, who then spends a portion of it, and so on. This continues until all the money leaks out through savings, taxes, or imports. However, measuring the exact multiplier is challenging due to varying leakages, time delays, and fluctuating economic conditions.

Factors influencing the multiplier size

• Leakages from the circular flow - Higher leakages (e.g., through saving or imports) reduce the multiplier.
• Income levels - Lower-income groups and less developed economies tend to spend more of their additional income, leading to a larger multiplier.
• Tax rates - Lower marginal tax rates keep more money in circulation, increasing the multiplier.

Marginal and average propensities to consume and save

Propensities measure how income is divided between spending and saving, which directly affects the multiplier effect. Average propensities relate to total income, while marginal propensities focus on changes in income.

Average propensity to consume (APC)

APC shows the proportion of total income spent on consumption.

$\text{APC}=\frac{\text{consumption}}{\text{total income}}$

Where:

• Consumption = Total spending on goods and services
• Total income = Overall earnings in the economy

Average propensity to save (APS)

APS indicates the proportion of total income that is saved.

$\text{APS}=\frac{\text{amount saved}}{\text{total income}}$

Where:

• Amount saved = Total savings
• Total income = Overall earnings in the economy

Marginal propensity to consume (MPC)

MPC represents the share of additional income spent on consumption. A higher MPC leads to a stronger multiplier as more money recirculates.

$\text{MPC}=\frac{\text{change in consumption}}{\text{change in income}}$

Marginal propensity to save (MPS)

MPS shows the share of additional income that is saved.

$\text{MPS}=\frac{\text{change in saving}}{\text{change in income}}$

Calculating the multiplier using MPC and MPW

The multiplier can be calculated using either MPC or the marginal propensity to withdraw (MPW), which accounts for all income removed from circulation.

Marginal propensity to withdraw (MPW)

MPW is the total proportion of extra income withdrawn through saving, taxation, or imports.

$\text{MPW}=\text{MPS}+\text{MPT}+\text{MPM}$

Where:

• MPS = Marginal propensity to save
• MPT = Marginal propensity to tax (marginal tax rate)
• MPM = Marginal propensity to import

MPC and MPW add up to 1, as additional income is either spent or withdrawn.

Calculating the multiplier with MPC

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

Where:

• MPC = Marginal propensity to consume

Calculating the multiplier with MPW

$\text{Multiplier}=\frac{1}{\text{MPW}}$

Worked example - Calculating the multiplier using MPC

An economy receives an injection of £150 million. If every extra £1 of income results in 60p being spent on domestic goods and services, calculate the multiplier and the total increase in national income.

Step 1: Identify the values

• Change in consumption per £1 = £0.60
• Injection = £150 million

Step 2: Determine the MPC

$\text{MPC}=\frac{\text{change in consumption}}{\text{change in income}}$

$\text{MPC}=\frac{0.60}{1}=0.60$

Step 3: Calculate the multiplier

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

$\text{Multiplier}=\frac{1}{1-0.60}$

$\text{Multiplier}=\frac{1}{0.40}=2.5$

Step 4: Calculate total increase in national income

Total increase = injection × multiplier

Total increase = £150 million × 2.5 = £375 million

Worked example - Calculating the multiplier using MPW

In an economy, the marginal propensity to save is 0.20, the marginal propensity to tax is 0.25, and the marginal propensity to import is 0.15. Calculate the multiplier for this economy.

Step 1: Identify the components of MPW

• MPS = 0.20
• MPT = 0.25
• MPM = 0.15

Step 2: Calculate MPW

MPW = MPS + MPT + MPM
MPW = 0.20 + 0.25 + 0.15 = 0.60

Step 3: Calculate the multiplier

$\text{Multiplier}=\frac{1}{\text{MPW}}$

$\text{Multiplier}=\frac{1}{0.60}\approx 1.67$