2.2.

4 Aggregate demand and the level of

economic activity

Are cash handouts the best way to

boost growth?
Use your knowledge of aggregate
demand and the multiplier effect to
answer this question.
AQA 2.2 HOW THE MACROECONOMY
WORKS:
THE CIRCULAR FLOW OF INCOME,
AGGREGATE DEMAND/AGGREGATE SUPPLY
ANALYSIS AND RELATED CONCEPTS
 2.2.4 WHAT YOU NEED TO KNOW

 The role of aggregate demand in influencing the

level of economic activity
 The multiplier process
 The concept of the marginal propensity to consume
 How to use the marginal propensity to consume to
calculate the size of the multiplier
 Understand why the size of the marginal propensity
to consume determines the magnitude of the
multiplier effect
 2.2.4 YEAR 1 RECAP:

 What is the role of aggregate demand in influencing

the level of economic activity in an economy?

 Can you explain the role of the multiplier in an

economy?
 THE MARGINAL PROPENSITY TO CONSUME

The marginal propensity to consume (MPC) measures the

What is your MPC?
If you were given proportion of extra income that is spent on consumption
£100 today how much
would you spend? For example, if you receive an extra £100 of income, and you
Would your MPC
change if it was decide to spend £80, and save the remainder, then the MPC will be
£1000? £80/£100 = 0.8
The MPC therefore measures:
Change in Consumption
Change in Income
The MPC is usually between 0 and 1

In rare instances, the MPC might be greater than 1 e.g. extra
income of £100 leads to additional consumption of £110 (i.e. a MPC
of 1.1). The extra £10 would be financed by new borrowing or
reducing savings and is usually an indication of high levels of
confidence in an economy
 FACTORS AFFECTING THE MPC

 Interest rates
 Low interest rates may encourage consumption rather
than saving, and so the MPC might be high
 Confidence
 If confidence is high, people may be encouraged to
spend, whereas if individuals are worried about job
prospects or an economic slump, the MPC is likely to fall
 Income levels
 If individuals have low incomes, then any increase in
Why are people over income is likely to be spent, so these people tend to have
55 withdrawing from
their pension pots? a high MPC. However, higher earners are more likely on
average to save and tend to have a slightly lower MPC
 THE MPC AND THE MULTIPLIER

 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

 The MPC will determine the size of the multiplier, and the
higher the MPC, the larger the multiplier effect will be

 The multiplier formula is therefore critical in understanding

this
Multiplier = 1/(1-MPC)
 THE MPC AND THE MULTIPLIER
WORKED EXAMPLES

Multiplier = 1/(1-MPC)

If MPC is 0.6 and

Example 1
there is an increase in
income of £1 m in the If the MPC is 0.8 then
economy how much __ 1__ = 5
will be generated (1-0.8)
through the
multiplier effect?
Therefore, if there is an extra £100 of income in a country, it will generate an extra £500 of
additional income through the multiplier effect.

Example 2
If the MPC increases to 0.9 as a result of rising confidence then
__ 1__ = 10
(1-0.9)
Therefore, if there is an extra £100 of income in a country, it will generate an extra £1,000 of
additional income through the multiplier effect.

As you can see, a relatively small change in the value of the MPC can have a very large
bearing on the magnitude of the multiplier effect.