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

This guide follows 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). It covers sections 3.2.2.4 (aggregate demand and the level of economic activity), 3.2.2.5 (determinants of short-run aggregate supply) and 3.2.2.6 (determinants of long-run aggregate supply). Section 3.2 is International AS content; the extra International A2 content sits in sections 3.3 and 3.4.

All figures, countries and firms below are invented for teaching. They are not real statistics.

Go to the OxfordAQA A-level Economics hub and the printable checklist. Then use the revision notes and the practice questions. For index numbers and real versus nominal data, see Measurement of Macroeconomic Performance. To find weak spots first, try the free 10-minute diagnostics.

What you must be able to do

Section	Outcome
3.2.2.4	Explain the role of AD in influencing the level of economic activity; explain the multiplier process and why an initial change in expenditure may lead to a larger change in local or national income; calculate the value of the multiplier
3.2.2.5	State that the price level and production costs are the main determinants of SRAS; distinguish movements along from shifts of SRAS; explain how money wage rates, raw material prices, indirect taxes and productivity shift SRAS
3.2.2.6	Explain the fundamental determinants of LRAS: capital stock, technology, working population, productivity, attitudes, enterprise, factor mobility and economic incentives; link the vertical LRAS curve to normal capacity output; understand the Keynesian view that an economy can stay far below normal capacity for years

Aggregate demand and the level of economic activity (3.2.2.4)

The role of AD

Aggregate demand is total planned spending on a country’s output at each price level. The level of economic activity (output, employment and incomes) depends heavily on it, because firms produce what they expect to sell.

• AD below normal capacity. Firms have spare capacity and workers are unemployed. A rise in AD mainly raises real output and employment, with little pressure on prices.
• AD close to normal capacity. Resources are scarce, so a rise in AD mainly raises the price level.

The size of the gap between actual output and normal capacity output is the output gap. A negative gap means demand-deficient (cyclical) unemployment is likely.

The multiplier process

An injection (investment, government spending or exports) becomes income for someone. They spend part of it on domestic output, which becomes another person’s income, and so on. The part not re-spent is a withdrawal (leakage): saving, tax or spending on imports.

The multiplier, k, compares how far national income finally moves with the size of the first injection that set it off.

• k = final change in income ÷ first change in injection
• k = 1 ÷ (1 − MPC), where MPC is the fraction of each extra unit of income that goes back into buying domestic output
• k = 1 ÷ MPW, where MPW = MPS + MPT + MPM (the marginal propensity to withdraw)

The three forms agree because MPC (spent at home) + MPW = 1.

Worked example 1: the multiplier and its rounds

Country A (illustrative) has MPS = 0.08, MPT = 0.12 and MPM = 0.20. The government spends an extra 36m on a road scheme.

1. MPW = 0.08 + 0.12 + 0.20 = 0.40
2. k = 1 ÷ 0.40 = 2.5
3. Change in income = 36 × 2.5 = 90m

Check by rounds. 60% of each round is re-spent at home (1 − 0.40).

Round	New spending (m)	Cumulative income (m)
1	36.00	36.00
2	21.60	57.60
3	12.96	70.56
4	7.78	78.34
5	4.67	83.00

The remaining rounds add about 7.0m, so the total approaches 90m. The multiplier works in reverse too: if exports fall by 15m, income falls by 15 × 2.5 = 37.5m.

Worked example 2: closing a gap

Country A has normal capacity output of 1,000m and actual output of 940m, so the gap is 60m (6.0% of capacity). A planner believes k = 4.

• Injection needed = 60 ÷ 4 = 15m.

If the true multiplier is only 2.5 (higher leakages than assumed), a 15m injection raises income by 37.5m, leaving 22.5m of the gap. The method is simple. The difficulty is knowing k, which is why such estimates are uncertain.

Worked example 3: a local multiplier

The idea applies locally. A small town gains a workshop that pays 2m a year in wages to residents. They spend 55% of extra income inside the town.

• Local k = 1 ÷ (1 − 0.55) = 2.22
• Extra local income = 2 × 2.22 = 4.44m

A small town has a lower local multiplier than a nation with the same tastes would have, because more spending on imports from outside leaks out.

Evaluating the size of the multiplier

• Leakages. Higher MPS, MPT or MPM mean a smaller k.
• Spare capacity. If the economy is near normal capacity, extra spending raises prices more than output, so real income rises by less than the formula suggests.
• Time. Each round takes time, so the full effect may take months or years.
• Expectations. If households expect higher taxes later, they may save more, which raises MPS.
• Size and direction. The same value of k magnifies falls in injections as well as rises.

Determinants of short-run aggregate supply (3.2.2.5)

SRAS shows the total real output firms are willing to supply at each price level when production costs are given. It slopes upward: if the price level rises while costs such as money wages stay fixed for a time, production becomes more profitable and firms supply more.

Movement along or shift?

Cause	Effect on SRAS
Change in the price level (for example from a change in AD)	Movement along the curve
Change in production costs	Shift of the whole curve

Worked contrast, for Country A:

• AD rises. The price level goes from 100 to 105 (+5.0%) and output from 980 to 1,000 (+2.0%). This is a movement up the SRAS curve.
• Starting again from a price level of 100 and output of 1,000, raw material prices rise. At the old price level firms supply less, so SRAS shifts left. The price level rises from 100 to 106 (+6.0%) and output falls from 1,000 to 970 (-3.0%). Rising prices alongside falling output is cost-push inflation.

The four cost factors in the specification

Factor	Change	SRAS
Money wage rates	Rise	Shifts left
Raw material prices	Fall	Shifts right
Indirect taxes	Rise	Shifts left
Productivity	Rise	Shifts right

Productivity matters through cost per unit. Suppose workers earn 20 an hour and produce 40 units, so labour cost per unit is 0.50. Wages rise 6% and productivity rises 2%:

• Labour cost per unit = (20 × 1.06) ÷ (40 × 1.02) = 21.20 ÷ 40.80 = 0.5196
• Change = +3.9%. SRAS shifts left.

If productivity had also risen 6%, the cost per unit would stay at 0.50, so a pay rise alone does not necessarily shift SRAS left.

Determinants of long-run aggregate supply (3.2.2.6)

In the model the specification uses, LRAS is vertical. Its position shows the normal capacity level of output. The price level does not change it, so only the fundamental determinants do.

Determinant	How it raises normal capacity
Capital stock	More machines and buildings per worker
Technology	New methods give more output from the same inputs
Working population	More people able and willing to work
Productivity	More output per worker, for example through training
Attitudes	A culture of effort, trust and acceptance of change
Enterprise	More start-ups and risk-taking
Factor mobility	Resources move easily between regions and jobs, reducing structural mismatch
Economic incentives	Rewards for working, saving and investing encourage supply

Underlying growth is a rightward shift of LRAS (section 3.2.2.2).

Worked example 4: capacity growth and the gap

Country A has 10m workers, each producing 100,000 a year, so normal capacity is 10m × 100,000 = 1,000bn. Next year the workforce rises 1% and output per worker 2%.

• New capacity = 1,000 × 1.01 × 1.02 = 1,030.2bn
• Capacity growth = 3.02%, slightly more than 1% + 2% because the two effects compound.

Actual output was 940bn (gap −6.0%). If it grows to 960bn (+2.1%), the gap becomes (960 − 1,030.2) ÷ 1,030.2 = −6.8%. Actual growth was positive, but because capacity grew faster, the gap widened.

The Keynesian view

Many economists think the economy returns to normal capacity automatically because wages and prices adjust. The Keynesian view in the specification is that an economy can get stuck producing well below normal capacity for many years. The reasoning chain:

1. AD falls, and firms cut output and jobs.
2. Wages and prices fall slowly because workers resist pay cuts and firms are cautious.
3. Weak demand and low confidence keep investment low, so the economy stays at an equilibrium below LRAS.
4. Since the wait may be long, the Keynesian conclusion is that AD should be raised deliberately.

Evaluation: the idea is persuasive when unemployment persists, but stimulus could be wasted or inflationary if the output gap is smaller than estimated.

Common errors

• Writing k = 1 ÷ MPC. It is 1 ÷ (1 − MPC) or 1 ÷ MPW.
• Using a multiplier of 2.5 as though income rises by 2.5, not by injection × 2.5.
• Shifting SRAS when the price level changes. That is a movement along.
• Shifting LRAS for a rise in the price level, or for a rise in AD.
• Treating higher productivity only as a long-run effect; it also lowers costs per unit, so it can shift SRAS.
• Listing determinants without explaining the link to output capacity.

Official syllabus

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