Aggregate demand and supply

Consumption, investment, government spending and net exports. The AD curve slopes down for reasons that are not the ones behind an ordinary demand curve: a higher price level reduces the real value of money balances (the wealth effect), tends to raise interest rates and so cut investment and consumption (the interest-rate effect), and makes domestic goods dearer relative to foreign ones, cutting net exports (the international-trade effect).

A change in the price level moves along AD. Anything else shifts it:

An injection into the circular flow raises income by more than itself, because the recipients spend part of what they receive and that becomes someone else’s income, and so on:

MPC is the marginal propensity to consume — the fraction of extra income spent on domestic output — and the withdrawals are saving, taxation and imports. With an MPC of 0.8, the multiplier is 5, so $10 billion of government spending eventually raises national income by $50 billion. A high propensity to import or a high tax rate shrinks the multiplier, which is one reason the same stimulus works differently in different economies.

The multiplier makes AD shift further than the initial injection — an important point when a question asks how large the effect of a policy will be, and the accelerator (investment responding to the rate of change of output) can amplify it further.

• SRAS slopes upward: with money wages and some input prices fixed in the short run, a higher price level raises profit margins and firms produce more. It shifts when production costs change — wages, raw materials, oil, indirect taxes, the exchange rate feeding into import prices.
• LRAS is vertical (in the classical view) at the full-employment or potential output, because in the long run output depends on the quantity and productivity of factors of production, not on the price level. It shifts only with the economy’s productive capacity: more or better labour, investment in capital, technology, education and training, or institutional reform.

The Keynesian version of the AS curve is drawn differently — flat where there is heavy spare capacity, then rising, then vertical at full capacity — and the shape matters because it changes what a rise in AD does. On the flat portion, extra demand raises output with no inflation; near the vertical portion it raises prices with little extra output. That difference is the standard evaluation on any demand-side policy question.

Macroeconomic equilibrium is where AD crosses AS. Comparing it with LRAS gives the output gap:

• Negative output gap — equilibrium output below potential. Spare capacity, cyclical unemployment, weak inflationary pressure. The case for demand-side expansion.
• Positive output gap — equilibrium output above potential, sustainable only briefly. Labour shortages and rising inflation. The case for contraction.

Economic growth splits along the same line: actual growth is a rightward shift of AD (or a movement toward LRAS) using existing capacity, while potential growth is a rightward shift of LRAS. Only the second raises the economy’s long-run capability, which is why supply-side policy is judged on whether it moves LRAS.

The evaluative sentence that applies to every demand-side policy: the effect on output depends on where the economy is on its supply curve. Expanding AD when there is a large negative output gap raises real GDP with little inflation; doing it at full capacity raises the price level and leaves output where it was.

• Demand-pull — AD shifts right against an upward- sloping or vertical AS. Prices rise, and output rises too unless the economy is already at capacity. Caused by a consumer boom, an expansionary policy, or strong export demand.
• Cost-push — SRAS shifts left: higher wages, higher oil or commodity prices, a depreciation raising import costs, a rise in indirect taxes. Prices rise and output falls — stagflation — which is what makes it the harder problem, since demand-side policy cannot fix both at once.

Which one a question describes decides the right policy, and the trade-off between unemployment and inflation is why macro objectives conflict. That conflict is the standard evaluation on section 10 questions.

Three questions in the paper’s shape — Quanta’s own:

All 9708 Paper 3 sittings → — each with its split across the five A2 sections.

1. 1.Shifting AD when the price level changes

   A change in the price level is a movement along AD. Only a change in C, I, G or net exports shifts the curve.

2. 2.SRAS and LRAS shifted by the same thing

   SRAS moves with production costs; LRAS moves only with productive capacity. A wage rise shifts SRAS; a training programme shifts LRAS.

3. 3.The multiplier taken from the MPC alone

   Use all withdrawals: 1 ÷ (MPS + MPT + MPM). Ignoring tax and imports overstates it, often by a factor of two or more.

4. 4.Actual growth confused with potential growth

   Actual growth uses spare capacity (AD right); potential growth raises capacity (LRAS right). Supply-side policy is judged on the second.

5. 5.Demand-side policy prescribed for cost-push inflation

   Contracting AD to fight cost-push inflation deepens the fall in output. Say why the source of the inflation changes the right response — it is the evaluation the question is looking for.