AQA A-Level Economics: Aggregate Demand and Aggregate Supply

Read the following extract and answer the question that follows.

The following extract was written for this exercise.

Marenia is a medium-sized open economy that spent several years growing only sluggishly, with unemployment well above its pre-slump level and many firms reporting idle plant and equipment. Last year the mood changed sharply. A widely respected survey of business confidence jumped to a record high after the central bank signalled a long period of low interest rates, and consumer confidence followed. Firms responded by bringing forward investment projects they had previously shelved, while households, feeling more secure in their jobs, increased their spending on cars and home improvements. Forecasters now expect aggregate demand to keep rising over the coming year. Some commentators welcome the recovery as overdue, pointing to the spare capacity the economy still has. Others warn that, with the labour market tightening and skill shortages appearing in construction and engineering, much of any further increase in demand could spill into higher prices rather than higher output.

Marenia: components of aggregate demand (£bn, constant prices)	Year 1	Year 2
Consumption (C)	620	650
Investment (I)	180	220
Government spending (G)	200	200
Net trade (X - M)	0	-10
Aggregate demand (AD)	1,000	1,060
Real GDP growth (% per year)	1.5	4.0
Output gap (% of potential GDP)	-2.0	+0.5

Question: Evaluate the likely effects of the rise in aggregate demand on Marenia's real output and price level, and assess how far those effects depend on the state of aggregate supply. [25 marks]

The government of an economy plans a large rise in spending that will increase aggregate demand. A government adviser argues that the effect of this rise on output and the price level will depend on how much spare capacity the economy currently has.

Explain, using the Keynesian view of aggregate supply, why the effect of a rise in aggregate demand on real output and the price level depends on the amount of spare capacity in the economy, with the help of a diagram. [15 marks]

An economy is operating at its full-employment level of output. The central bank then cuts interest rates, which raises aggregate demand.

Analyse, using the classical view of aggregate supply, why an increase in aggregate demand raises only the price level in the long run, with the help of a diagram. [9 marks]

In the economy of Tessador, the marginal propensities out of each extra pound of national income are shown in the table below.

Marginal propensity	Symbol	Value
To consume	MPC	0.80
To save	MPS	0.10
To tax	MPT	0.05
To import	MPM	0.05

The government raises its spending by £12bn, with the economy operating below full capacity.

Calculate the value of the multiplier and the resulting change in Tessador's real GDP. (6 marks)

Firms in the economy of Calderon increase their investment after a fall in the cost of borrowing.

Explain how the rise in investment affects aggregate demand and, through the multiplier, the level of national income in Calderon. (5 marks)

In the economy of Norhaven, an increase in national income of £8bn is accompanied by a rise in consumption of £6bn. Assume a simple economy in which the only withdrawal is saving.

Calculate the marginal propensity to consume (MPC) and hence the value of the multiplier in Norhaven. (4 marks)