AQA A-level Economics: Aggregate demand and activity, short-run and long-run AS (7136) – Revision Notes

These notes condense three sub-sections of the AQA AS and A-level Economics specification, version 1.3: aggregate demand and the level of economic activity, determinants of short-run aggregate supply, and determinants of long-run aggregate supply. The AQA website numbers them 3.2.2.4, 3.2.2.5 and 3.2.2.6; the combined PDF prints the A-level wording as 4.2.2.4 to 4.2.2.6. For fuller explanations see the AQA study guide on how the macroeconomy works, then try the practice questions. Find the course hub at AQA A-level Economics, tick off topics on the printable checklist and use the free diagnostics to spot weak areas. All countries and figures below are invented.

Key definitions

Term	Meaning
Aggregate demand (AD)	Spending plans for the whole economy’s output, one figure for each possible price level
Multiplier	Final change in income divided by the initial change in expenditure
Marginal propensity to consume (MPC)	Change in consumption divided by change in income
Short-run aggregate supply (SRAS)	Output firms will supply at each price level while costs are given
Long-run aggregate supply (LRAS)	Output at normal capacity, set by the quantity and quality of resources
Normal capacity output	The level of output the economy can sustain with resources normally employed
Productivity	Amount produced for each worker-hour or other unit of resource used
Keynesian AS	A curve flat when there is spare capacity, rising as bottlenecks appear, vertical at full capacity

3.2.2.4 Aggregate demand and the level of economic activity

Role of AD. In the short run the level of activity (real output, employment, and so the pressure on prices) depends on AD. If AD is too low, firms cut output and jobs. If AD grows faster than capacity allows, price pressure builds.

Why the multiplier exists. Spending by one person is income for another. A part of that income is spent again, and so on. The first round is the initial change in expenditure, so the final rise in income is larger. It can apply to a town (local income) or to a nation.

Formula, using MPC only (the specification says you calculate the multiplier from the MPC and are not expected to use marginal propensities to withdraw):

MPC = change in consumption / change in income
multiplier = 1 / (1 - MPC)
change in income = initial change in spending x multiplier

MPC	1 - MPC	Multiplier
0.5	0.5	2
0.6	0.4	2.5
0.75	0.25	4
0.9	0.1	10

Why the size of the MPC sets the size of the multiplier. Each round passes on MPC of the previous round. A high MPC means little is lost at each stage, so the chain is long and the total large. A low MPC means the chain dies quickly.

Rounds shown out (Country K, an extra 20 bn cu of spending, MPC 0.6):

Round 1: 20.0
Round 2: 20 x 0.6 = 12.0
Round 3: 12 x 0.6 = 7.2
Round 4: 7.2 x 0.6 = 4.32
Round 5: 4.32 x 0.6 = 2.592
Five rounds total: 46.112
Limit: 20 x 2.5 = 50

MPC from data. Income rises from 400 to 500 and consumption from 300 to 375: MPC = 75/100 = 0.75, multiplier = 4.

Local multiplier. If only 40% of extra income is spent on goods made in the town, treat 0.4 as the share passed on locally: 1/(1 - 0.4) = 1.67. A town leaks more spending than a nation, so its multiplier is smaller.

Working backwards. An output gap of 120 with multiplier 4 needs an injection of 120/4 = 30, if prices do not rise and there is spare capacity. A fall in spending works in reverse: a cut of 30 with MPC 0.8 lowers income by 30 x 5 = 150.

Evaluating the multiplier.

• It is largest with spare capacity. Near full capacity extra demand mainly raises prices, so real output rises less.
• The MPC is not fixed. Falling confidence or high debts can lower it; expectations of rising incomes can raise it.
• Time matters: the rounds take months, and the policy may be reversed before the full effect.
• Some spending leaks abroad or into saving and tax, so the multiplier in practice is smaller than a formula using only the MPC suggests.

Worked reminder: AD shift and the price level

Country K: AD is Y = 1300 - 4P and SRAS is Y = 600 + 3P, with Y in bn cu and P an index. Equilibrium: 1300 - 4P = 600 + 3P, so 7P = 700, P = 100 and Y = 900.

Investment rises by 17.5 and the multiplier is 4, so AD shifts right by 70: Y = 1370 - 4P. Then 770 = 7P, P = 110 and Y = 930. Output rises only 30 (3.3%), not 70, because prices rise 10% along the upward-sloping SRAS. The multiplier gives the shift in AD. The slope of AS decides how much of it appears as output.

3.2.2.5 Determinants of short-run aggregate supply

Main determinants: the price level and production costs.

• When the price level changes, the economy moves along SRAS. Higher prices with costs unchanged make production more profitable, so firms supply more.
• A change in costs shifts SRAS. Higher costs shift it left (or up); lower costs shift it right (or down).

Cost change	Why it shifts SRAS
Money wage rates rise	Labour cost per unit rises unless productivity rises as much
Raw material prices rise	Input costs rise, in proportion to their share of total cost
Business taxation rises	Tax raises the cost of employing labour or producing output
Productivity rises	Same inputs make more output, so unit costs fall

Unit labour cost = wage index / productivity index. Wages +4% and productivity +2.5%: 104/102.5 = 1.0146, so unit labour cost rises 1.46%. Wages can rise without shifting SRAS left if productivity keeps pace.

Share of costs. If raw materials are 30% of costs and their price rises 20%, total costs rise by 0.3 x 20 = 6%, other costs unchanged. Business taxation: an employer charge rising from 10% to 12% of a wage of 100 lifts the cost of a worker from 110 to 112, which is 1.8%.

Cost shock, shown with numbers. Suppose a cost rise shifts SRAS to Y = 570 + 3P. With AD unchanged at Y = 1300 - 4P: 730 = 7P, so P = 104.3 and Y = 882.9. Output falls 17.1 (1.9%) and the price level rises 4.3%. This is a supply-side shock giving lower output with higher prices.

Chain. Raw material prices rise, unit costs rise, SRAS shifts left, price level rises, output and employment fall.

Do not confuse: lower SRAS costs from higher productivity can be temporary or lasting. A lasting rise in productivity is also a long-run effect (below).

3.2.2.6 Determinants of long-run aggregate supply

The LRAS curve is vertical, drawn at the normal capacity level of output. In the long run, output is set by the quantity and quality of resources, not by the price level. A rise in AD then changes the price level but not capacity output.

Fundamental determinants.

Determinant	Mechanism
Technology	New methods raise output from the same inputs
Productivity	More output per worker or machine, through skills, capital or organisation
Attitudes	Willingness to work, take risks, train or accept change
Enterprise	New firms and ideas raise the use and combination of resources
Factor mobility	Resources can move to where they are most productive, which cuts structural waste
Economic incentives	Rewards for working, investing and innovating

Capacity arithmetic. Normal capacity = workers at normal employment x output per worker. For example, 20 million workers at 46,000 cu each gives 920 bn cu. If employment rises 1% and output per worker 3%: 1.01 x 1.03 = 1.0403, so capacity rises 4.03% to 957.1 bn.

Output gap = (actual output - normal capacity) / normal capacity x 100. Actual 900 against 920 gives -2.17%, so there is spare capacity. Actual 930 gives +1.09%, so demand pressure is above sustainable output.

Institutional structure. The way an economy is organised helps decide how much it can produce. The banking system is the example the specification gives: when banks turn savings into loans for businesses, investment in capital rises, and capacity can grow faster. If banks cannot or will not lend, investment funds dry up and growth in capacity slows. Other institutions (for example, a legal system that protects property) work in the same way, although the specification names only banking.

Chain. Better training or technology raises productivity, so output per worker rises at any price level, so LRAS shifts right and the normal capacity level of output increases.

The Keynesian AS curve

Price level
   |                      /  <- vertical at maximum output
   |                    /
   |                 _/    <- rising as shortages bite
   |_______________/       <- flat while resources are idle
   +----------------------- Real output

Equilibrium output	Price index	Reading
600 to 800	100	Flat: AD rises, output rises, prices unchanged
900	108	Rising: output and prices both rise
980 (maximum)	140	Vertical: AD rises, only prices rise

From 800 to 900 output rises 12.5% and prices 8%. In the vertical section further AD raises only prices.

Keynesian curve versus vertical LRAS. The Keynesian curve says the economy can settle below capacity for a long time, so raising AD is useful. The vertical LRAS view says demand cannot raise capacity output, so only supply-side change can. Say which view you use, and why it fits the evidence in the question.

Must-know distinctions

• Movement along SRAS (price level) versus shift of SRAS (costs).
• SRAS shift (can be a one-off cost change) versus LRAS shift (capacity changes).
• Multiplier effect on AD versus effect on real output (depends on spare capacity).
• Local multiplier (more leakage) versus national multiplier.

Quick self-test

1. Consumption rises by 60 when income rises by 80. Calculate the MPC and multiplier.
2. Calculate the multiplier when MPC is 0.9.
3. Government spending rises 15 and MPC is 0.8. Calculate the change in income.
4. Explain why a larger MPC gives a larger multiplier.
5. Wages rise 3% and productivity 1.5%. Calculate the change in unit labour cost.
6. State two causes of a leftward shift in SRAS.
7. Actual output is 540 and normal capacity is 600. Calculate the output gap.
8. Give two determinants of LRAS and one way each raises capacity.
9. Explain why the Keynesian AS curve is flat at low output.
10. Explain how banking helps LRAS.

Answers

1. MPC = 60/80 = 0.75; multiplier = 1/0.25 = 4.
2. 1/(1 - 0.9) = 10.
3. Multiplier 5, so 15 x 5 = 75.
4. Less is lost at each round, so spending is passed on through more rounds.
5. 1.03/1.015 = 1.0148, a rise of 1.48%.
6. Higher money wage rates without extra productivity; higher raw material prices; higher business taxation.
7. (540 - 600)/600 = -10%.
8. For example, technology (more output from the same inputs) and enterprise (new firms combine resources more effectively).
9. Spare resources can be taken up without bidding up costs, so firms can raise output at constant prices.
10. It channels savings into loans for firms, raising investment in capital and so capacity.

Where marks are usually lost

• Using 1/MPC for the multiplier when the formula is 1/(1 - MPC).
• Stating that the multiplier always gives the final rise in real output, with no mention of spare capacity.
• Showing a rise in the price level as a shift of SRAS rather than a movement along it.
• Saying that higher wages always shift SRAS left, ignoring productivity.
• Drawing LRAS as vertical but not saying it marks normal capacity output.
• Listing determinants of LRAS with no mechanism to capacity.
• Describing the Keynesian curve without saying which section applies to the question.
• Giving no judgement in evaluation, only a list.

Official syllabus

AQA, AS and A-level Economics specification, version 1.3 (29 June 2022), A-level content sections 4.2.2.4 to 4.2.2.6 in the combined PDF (3.2.2.4 to 3.2.2.6 on the AQA website). Published by AQA.