OxfordAQA International AS and A-level Economics: Aggregate demand, SRAS and LRAS (9640) – Revision Notes

These notes condense sections 3.2.2.4 to 3.2.2.6 of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2 (International AS exams from May/June 2021, International A-level exams from May/June 2022). Section 3.2 is International AS content. For full explanations start with the study guide, then test yourself with the practice questions.

Other links: the course hub, the printable checklist and the free 10-minute diagnostics. All figures below are invented for revision.

Key definitions

Term	Meaning
Aggregate demand (AD)	Total planned spending on a country’s output at each price level
Level of economic activity	Output, employment and incomes in the economy, strongly influenced by AD
Injection	Spending entering the flow from outside household spending: investment, government spending, exports
Withdrawal (leakage)	Income not re-spent on domestic output: saving, tax, imports
Multiplier (k)	How many times larger the final rise or fall in income is than the first injection
SRAS	Real output firms will supply at each price level, with production costs given
LRAS	Vertical curve at the normal capacity level of output
Normal capacity output	The level of output shown by the position of the vertical LRAS curve

Multiplier: formulas and method

Version	Formula
From income	k = final change in Y ÷ first change in injection
From MPC	k = 1 ÷ (1 − MPC), where MPC is the fraction of extra income that goes to domestic output
From withdrawals	k = 1 ÷ MPW, with MPW = MPS + MPT + MPM

Working order:

1. Find MPW by adding MPS, MPT and MPM (or take 1 − MPC).
2. Divide 1 by that figure to find k.
3. Multiply the change in injection by k. A fall in injection gives a negative answer.
4. To find the injection needed for a target, divide the gap by k.
5. Comment: leakages, spare capacity, time lags.

Worked reminders (all invented):

• MPC = 0.75 so k = 1 ÷ 0.25 = 4. An investment rise of 12 gives 12 × 4 = 48. A fall in exports of 9 gives −36.
• MPS = 0.04, MPT = 0.16, MPM = 0.30, so MPW = 0.50 and k = 2. An injection of 25 raises income by 50.
• Output gap of 80 with k = 5 needs an injection of 80 ÷ 5 = 16.
• A local multiplier works the same way. If residents spend 40% of extra income locally, local k = 1 ÷ 0.60 = 1.67.

Why the real effect can be smaller than the formula:

• Higher leakages mean a smaller multiplier.
• Near normal capacity, extra demand raises prices, not real output.
• Rounds of spending take time.
• Expectations can change saving or tax behaviour.

AD and the level of economic activity

Position	What a rise in AD mainly does
Well below normal capacity (negative output gap)	Raises output and employment
Close to normal capacity	Raises the price level
Persistent weak AD	Can leave demand-deficient (cyclical) unemployment

Output gap (% of capacity) = (actual − capacity) ÷ capacity × 100. If actual output is 450 and capacity is 500, the gap is −10.0%.

SRAS: determinants

The price level and production costs are the main determinants. Remember the rule: price level changes mean a movement along; cost changes mean a shift.

Change in cost factor	SRAS	Typical effect
Money wage rates rise	Shifts left	Higher prices, lower output
Raw material prices rise	Shifts left	Cost-push pressure
Indirect taxes rise	Shifts left	Higher costs at each price level
Productivity rises	Shifts right	Lower cost per unit
Raw material prices or wage growth fall	Shifts right	Lower prices, higher output

Labour cost per unit of output = hourly wage ÷ units produced per hour. If wages and productivity both rise 5%, labour cost per unit is unchanged (1.05 ÷ 1.05 = 1.00). If wages rise 3% and productivity 1%, it rises by 1.03 ÷ 1.01 − 1 = 2.0%.

LRAS: determinants

LRAS is assumed vertical, and its position is the normal capacity level of output. A rightward shift is underlying economic growth.

Determinant	Link to capacity
Capital stock	More equipment per worker
Technology	More output from given inputs
Working population	More workers available
Productivity	More output per worker
Attitudes	Work ethic and openness to change
Enterprise	More new firms and risk-taking
Factor mobility	Easier movement of labour and capital to where they are needed
Economic incentives	Rewards that encourage work, saving and investment

Capacity growth compounds. If the workforce grows 2% and productivity 3%, capacity grows 1.02 × 1.03 − 1 = 5.06%, not 5%.

Diagrams in words

Label the vertical axis price level and the horizontal axis real output.

• Spare capacity. AD and SRAS cross to the left of the vertical LRAS line. The distance to LRAS is the negative output gap. Shift AD right and the equilibrium moves along SRAS towards LRAS, mostly raising output.
• Cost-push shock. SRAS shifts left. The price level ends up higher and real output lower, possibly further left of LRAS.
• Productivity gain. SRAS shifts right and, if it lasts, LRAS also shifts right. Price level falls or rises less and output rises.
• Underlying growth. LRAS shifts right. Mark the old and new normal capacity on the horizontal axis.
• Keynesian stuck point. AD and SRAS cross well left of LRAS. Show that no force in the diagram moves the equilibrium quickly.

Evaluation prompts

Ask these questions to move from describing to judging.

Claim	Ask
A rise in injections will raise income by k times	How large are leakages, and how close is the economy to capacity?
A rise in AD closes the output gap	Was the gap measured correctly, and how long will the rounds take?
Lower costs will shift SRAS right	Is the change temporary (a one-off price fall) or lasting (productivity)?
Raising capital stock raises LRAS	How long does it take, and is there enough demand to use the new capacity?
The economy will return to normal capacity by itself	Do wages and prices adjust quickly, or can it stay below for years?

Mini worked chain: why one shock matters

Suppose raw material prices rise in Country A (invented). Write the chain in this order:

1. Firms face higher costs at each price level.
2. SRAS shifts left.
3. The equilibrium price level rises and real output falls.
4. Employment tends to fall, so incomes and AD may weaken.
5. Judgement: the effect is larger if the economy has little spare capacity, and temporary if the price rise reverses.

Must-know distinctions

• Injection versus withdrawal. Injections raise the flow, withdrawals take from it. The multiplier depends on how much leaks at each round.
• Movement along versus shift. The price level moves you along SRAS. Costs shift it.
• SRAS versus LRAS. SRAS depends on costs given in the short run. LRAS depends on productive capacity.
• Actual versus potential growth. A rise in AD can raise actual output (if there is spare capacity). Only a rightward LRAS shift raises normal capacity.
• Keynesian view. An economy can stay well below normal capacity for many years, so waiting for wages and prices to adjust may be too slow. The counter-argument is that stimulus can be inflationary if the output gap has been overstated.

Quick self-test

1. Define the multiplier in your own words.
2. If 75% of extra income is re-spent on domestic output, what is k?
3. With that k, what is the effect of an injection of 12?
4. Exports fall by 9 and k = 4. What happens to income?
5. MPS = 0.04, MPT = 0.16 and MPM = 0.30. Find k.
6. Output gap is 80 and k = 5. What injection is needed?
7. Actual output is 450 and capacity is 500. Find the output gap as a percentage.
8. A rise in AD raises the price level. Is that a shift or a movement for SRAS?
9. Wages rise 3% and productivity 1%. What happens to labour cost per unit?
10. What does the position of the vertical LRAS curve represent?
11. State two determinants of LRAS.
12. Give the Keynesian view about normal capacity.

Answers

1. How many times larger the final change in income is than the first injection.
2. k = 1 ÷ (1 − 0.75) = 4.
3. 12 × 4 = 48.
4. It falls by 9 × 4 = 36.
5. MPW = 0.50, so k = 2.
6. 80 ÷ 5 = 16.
7. (450 − 500) ÷ 500 × 100 = −10.0%.
8. A movement along SRAS.
9. It rises by about 2.0%, so SRAS shifts left.
10. The normal capacity level of output.
11. Any two from capital stock, technology, working population, productivity, attitudes, enterprise, factor mobility, economic incentives.
12. An economy can get stuck well below its normal capacity level of output for many years.

Where marks are usually lost

• Using 1 ÷ MPC instead of 1 ÷ (1 − MPC).
• Forgetting that tax and imports are leakages as well as saving.
• Multiplying by k and calling the answer the multiplier, not the change in income.
• Drawing a shift of SRAS for a change in the price level.
• Shifting LRAS because AD rose.
• Naming a determinant of LRAS but not saying why it raises capacity.
• Stating the multiplier effect without a comment on spare capacity or leakages when the question asks for evaluation.
• Rounding percentages too early in a compounding calculation.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, first teaching September 2020, published by OxfordAQA.