Extra investment is only one cause for the multiplier effect on aggregate demand. Any increase of theinjections into the circular flow will lead to a multiple increase in income in the economy. So, an increase in Government spending would lead to a multiple increase in income, as would an increase in export spending.
Let’s take an example of an investment in Location A, The investment at Location A would cause a multiplier effect on income because when money is invested it circulates through the economy many times, adding to the national income. For example, the £468 million spent on the plant (plus the extra for the landscaping and other facilities) will go to the building contractors, who will spend most of it on wages, which will go to the workers (households). The workers, in turn, will spend a percentage of it on goods and services (money goes back to the firms) and the rest will be ‘withdrawn’ from the circular flow, i.e. it will go to the Government as tax or will be saved. The money that goes back to the firms will again be invested and spent on workers’ wages and the cycle continues, with each time the households taking a percentage for tax and savings, before passing the money on again. Hence, the cycle continues until all of the initial £468 million has been withdrawn from the cycle. At this point we can divide the total increase in income (i.e. the addition of all the values that have gone through the firms each time) and divide it by the initial investment to calculate the value of the multiplier. In this way the initial investment will not have caused the creation of 2,000 jobs, but many more.
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With reference to one factor, explain why some factors might shift the SRAS curve but leave the LRAS curve unchanged. (10 marks)
The short-run aggregate supply curve captures the relation between real production and the price level. As the price level rises, real production is greater. As the price level falls, real production also declines. The interaction between the short-run aggregate supply curve and the aggregate demand curve, as well as the long-run aggregate supply curve is the core mechanism of the aggregate market (AS-AD) analysis. This analysis is then used to explain and understand macroeconomic phenomenon, including business cycles, inflation, unemployment, and stabilization policies.
The long-run aggregate supply curve reflects the lack of a cause-and-effect relation between real production and the price level. As the price level rises, real production remains constant at the full-employment level. As the price level falls, real production remains constant at the full-employment level. Due to flexible prices, the same level of real production is generated at every price level.
Among the factors held constant in drawing a short-run aggregate supply curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production.
A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the short-run aggregate supply curve. A change in the quantity of goods and services supplied at every price level in the short run is a change in short-run aggregate supply. Changes in the factors held constant in drawing the short-run aggregate supply curve shift the curve. (These factors may also shift the long-run aggregate supply curve; we will discuss them along with other determinants of long-run aggregate supply in the next chapter.)
One type of event that would shift the short-run aggregate supply curve is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, all other things unchanged, raises the cost of production and leads to a reduction in short-run aggregate supply. A decrease in the price of a natural resource would lower the cost of production and, other things unchanged, would allow greater production from the economy’s stock of resources and would shift the short-run aggregate supply curve to the right.
In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run - we move up or down the short run aggregate supply curve.
In the long run we assume that supply is independent of the price level (money is said to be neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical.
Factors that affect SRAS curve but not the LRAS curve :
Wages: This is the price of labor, which works through the resource price determinant. It is the key determinant underlying the self-correction mechanism of the aggregate market. Wages affect the short-run aggregate supply curve, but not the long-run aggregate supply curve.
Energy Prices: These are the prices of key energy inputs, especially petroleum, that are essential to any modern industrialized economy. Like wages, energy prices also work through the resource price determinant. Also like labor, energy prices affect the short-run aggregate supply curve, but not the long-run aggregate supply curve.