What determines the total level of demand and supply in an economy, and how is equilibrium output set?
The components of aggregate demand, the short-run and long-run aggregate supply curves, macroeconomic equilibrium, and the multiplier effect.
A focused CCEA A-Level Economics answer on aggregate demand and supply, covering the four components of AD, the determinants that shift it, short-run and long-run aggregate supply, macroeconomic equilibrium and the output gap, and the multiplier effect, with a worked multiplier calculation.
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What this dot point is asking
CCEA wants you to define aggregate demand and its four components, explain what shifts the AD curve, distinguish short-run from long-run aggregate supply and what shifts each, find macroeconomic equilibrium and the output gap on an AD/AS diagram, and explain and calculate the multiplier effect.
Aggregate demand
AD slopes downward for macroeconomic reasons (a lower price level raises real wealth, lowers interest rates and makes exports cheaper). It shifts when a component changes:
- Consumption (C) - the largest component; driven by income, confidence, interest rates and wealth.
- Investment (I) - firms' spending on capital; driven by interest rates, confidence (animal spirits) and expected demand.
- Government spending (G) - set by fiscal policy.
- Net exports (X - M) - driven by exchange rates, world income and competitiveness.
Aggregate supply
SRAS shifts with costs of production - wages, raw materials, energy and indirect taxes. LRAS shifts with anything that changes productive capacity: investment, the size and skills of the workforce, technology and efficiency-raising supply-side policies. A rightward shift of LRAS is the same idea as potential economic growth and an outward shift of the production possibility frontier.
Macroeconomic equilibrium
The multiplier
Try this
Q1. State the four components of aggregate demand. [2 marks]
- Cue. Consumption, investment, government spending and net exports (X minus M).
Q2. Calculate the multiplier when the marginal propensity to withdraw is 0.25. [2 marks]
- Cue. Multiplier equals 1 divided by 0.25 equals 4.
Q3. Using a diagram, explain the effect of a rise in business investment on equilibrium output and the price level. [6 marks]
- Cue. AD shifts right; real output and the price level both rise, with the split depending on how much spare capacity exists.
Exam-style practice questions
Practice questions written in the style of CCEA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
CCEA AS 26 marksExplain, using an aggregate demand and aggregate supply diagram, the effect of a rise in consumer confidence on the macroeconomy.Show worked answer →
Worth 6 marks. Markers reward a labelled AD/AS diagram, the correct shift, and the effect on output and the price level.
Set up: draw AD downward sloping and AS (short run upward sloping), crossing at price level P1 and real output Y1.
Shift: higher consumer confidence raises consumption, the largest component of AD, so AD shifts right to AD2.
New equilibrium: the economy moves to a higher price level P2 and higher real output Y2, so growth and employment rise but so does inflationary pressure.
Development: the size of the effect depends on how much spare capacity there is. Near full capacity, most of the rise shows up as higher prices rather than higher output.
CCEA AS 28 marksExamine the factors that determine the size of the multiplier.Show worked answer →
Worth 8 marks. A strong answer defines the multiplier, links it to the leakages, and evaluates what makes it large or small.
Definition: the multiplier is the ratio of the final change in national income to the initial change in injection. An injection is re-spent, becoming income for others, who spend again.
Marginal propensities: the multiplier depends on the marginal propensity to withdraw. The larger the marginal propensities to save, tax and import, the more leaks out at each round and the smaller the multiplier.
Spare capacity: the multiplier raises real output most when there is spare capacity. Near full capacity, extra demand raises prices instead, so the real multiplier effect is weaker.
Judgement: a high marginal propensity to consume and plenty of spare capacity give a large multiplier, which is why fiscal stimulus is most effective in a recession with idle resources.
Related dot points
- The circular flow of income, the measurement of national income (GDP and GNI), real versus nominal values, economic growth, and the phases of the economic cycle.
A focused CCEA A-Level Economics answer on national income and growth, covering the circular flow of income with injections and withdrawals, GDP and GNI, real versus nominal and per-capita measures, the difference between actual and potential growth, and the phases of the economic cycle, with worked real-GDP reasoning.
- The measurement of unemployment, the types and causes of unemployment, and the economic and social consequences of unemployment.
A focused CCEA A-Level Economics answer on unemployment, covering the Claimant Count and Labour Force Survey measures, the types of unemployment (frictional, structural, cyclical, seasonal and real-wage), their causes, and the economic and social consequences, with a worked unemployment-rate calculation.
- The measurement of inflation using price indices, the causes of inflation (demand-pull and cost-push), deflation, and the consequences of changing prices.
A focused CCEA A-Level Economics answer on inflation, covering the Consumer Prices Index and Retail Prices Index, how a price index and the inflation rate are calculated, demand-pull and cost-push causes, deflation and disinflation, and the consequences of inflation, with a worked index calculation.
- The macroeconomic objectives, fiscal policy, monetary policy and supply-side policy, their effects on the economy, and the conflicts between objectives.
A focused CCEA A-Level Economics answer on macroeconomic policy, covering the four objectives, fiscal policy and the budget, monetary policy and interest rates, supply-side policy, how each affects AD or AS, and the conflicts between objectives such as growth versus inflation, with a worked policy analysis.
Sources & how we know this
- CCEA GCE Economics specification — CCEA (2016)