Aggregate Demand and the Level of Economic Activity

Candidates should have an understanding of the role of aggregate demand in influencing the level of economic activity. They should be aware of the multiplier process and be able to explain that an initial change in expenditure may lead to a larger impact on local or national income.
The Multiplier

The multiplier is an economic concept/theory which explains that when there is a change in one of the components of aggregate demand it leads to a more than proportionate change in real national output.

The idea of the multiplier is credited to Richard Khan (1905 - 1989). At the University of Cambridge, Khan was part of a discussion group that helped to provide John Maynard Keynes with ideas. The multiplier is a central component of Keynesian economic theory.

Keynes and Khan suggested that if there was an increase in investment by firms, the building of a new factory for example, there would be an increase in aggregate demand (a first-round effect). The building of the factory would require more labour and some of the extra wages paid to workers would in turn be spent by them (a second round effect). The money these workers spent would end up in the form of wages, profit, rent or interest in other industries - and the money earned by people in these industries would also spend at least some of this money (a third-round effect). Thus the money goes round the circular flow of income many times. However the process will not go on infinitely because workers do not spend all their money - they have a 'propensity' to spend some of it and a propensity to save some of it. So if the marginal propensity to consume is 80% then a 100 million pounds of investment injected into the circular flow would increase the total aggregate demand by 100+80+64+ 51.2 + 40.96.....and so on.

The exact increase in AD can be calculated by multiplying the injection into the circular flow by 1/1-MPC where MPC is the marginal propensity to consume. In our example this would be £100 x 1/1-0.8. In our example the answer would be £500 million. So if a £100 million injection into the circular flow results in a £500 million change in real national output then the size of the Keynesian multiplier is 5.

k = ∆Y ÷ ∆I where k is the multiplier, ∆Y is change in income and ∆I is the change in investment. In our example the multiplier k is equal to 500 ÷ 100 = 5.

The multiplier works for any new injection - so we write about investment multipliers, export multipliers and multiplier effects of government spending. There are also negative multiplier effects from reduced investment, government spending and exports. Increases in leakages from the circular flow: savings, taxes and imports will have negative multiplier effects and a reduction in them will have positive effects.

Chain of reason

1. In a recession the government decides to use expansionary fiscal policy.
2. Government spending is increased, for example new schools and roads are built.
3. Other things being equal, aggregate demand immediately increases ( a first round effect) and AD shifts to the right from AD1 to AD2.
4. The initial increase in government spending causes second and third round effects and so on in other industries as workers who built the roads and schools spend some of their extra income on goods and services, so AD increases further still..
5. The size of the increase in real national income, AD1 to AD3, is greater than the initial injection and this will depend on the size of the initial injection and the size of the Keynesian multiplier.
6. With the increase in real national income there will be a reduction in unemployment, and the negative output gap Yfe - Y1will will shrink.

Evaluation points

Discussing the magnitude of effects is one form of evaluating a situation. In many textbooks the size of the multiplier is shown as 5 or 10, this is because these numbers make nice easy calculations for students to understand. However, some economists believe the size of the multiplier in the United Kingdomn is much smaller than 5. This is because being a small island, which is far from self sufficient, quite a lot of any injection into the circular flow is spent on imports and leaks out of the system. The International Monetary Fund did some research trying to calculate the size of the UK's multiplier and suggested it could be about 1.7. However, it seems nobody has much idea of the actual size of the UK's multiplier. And if you don't know how large the multiplier is - how can anyone know what the full effect of a change in injections or leakages will be - including government policy makers?

Using expansionary fiscal policy will not be effective unless there is spare capacity in the economy i.e there is idle land, labour and capital and part finished or finished stock. But if the economy has little spare capacity then the effect of increased government spending will be to increase demand and push prices up from p1 to p2 causing a positive output gap and inflation.

Extension work

Q. Would an an increase in government spending of £100 have the same multiplier effect as a decrease in taxation of £100million ?

A. No - if the government increased spending by £100 million AD would go up by £100 million and this would have a further multiplied effect. However, if tax was reduced by £100 million, although people would be better of by £100million, which might seem like the same as an injection of government spending of a £100m, BUT if people wouldn't spend all of it - they would save some. So a £100 million reduction in taxes might only increase the size of AD by an initial £80 million plus a multiplied effect.

Q. Why might rich people have a lower marginal propensity to consume than poor people?

A. Poorer people will need to spend all their money on necessities such s housing and food, whilst richer people will have enough money to save some of their income. This is why Keynes thought progressive tax (higher % rates for higher income earners) coupled with higher government spending would help raise AD and get economies to recover from recessions quicker than leaving the free market to solve the problem.

Key terms

The multiplier - an economic theory which explains that when there is an initial change in one of the components of aggregate demand it leads to a more than proportionate change in real national output.

Positive multiplier - when an initial increase in an injection, or decrease in a leakage, leads to a greater final increase in real national output.

Negative multiplier - when an initial decrease in an injection, or an increase in a leakage, leads to a greater final decrease in real national income.

MPC - the marginal propensity to consume - the proportion of any new income that is spent on consumer goods and services.

MPS - the marginal propensity to save - the proportion of any new income that is saved.

MPM - the marginal propensity to import - the proportion of any new income that is spent on imports.