B) The impact of changing the level of AD on the economy as a whole

The idea

Changing the level of aggregate demand (AD) has significant impacts on the macroeconomic objectives of the whole economy. An increase in AD, perhaps driven by expansionary fiscal or monetary policy, typically leads to higher economic growth and lower unemployment as firms increase production. However, if the economy is operating near full capacity, this increase in AD can cause demand-pull inflation and potentially worsen the current account of the balance of payments as consumers buy more imports. Conversely, a decrease in AD can reduce inflationary pressures and improve the trade balance, but risks causing cyclical unemployment and lower economic growth. The exact impact depends on the initial level of spare capacity.

What earns the marks

• Explain that an increase in aggregate demand can lead to short-run economic growth and lower cyclical unemployment.
• Identify that rising aggregate demand can cause demand-pull inflation if the economy is operating close to full capacity.
• Explain that a decrease in aggregate demand can reduce inflation but may lead to higher unemployment and lower economic growth.
• Recognise that changes in aggregate demand can affect the current account balance, with higher demand often leading to increased expenditure on imports.

Common mistakes and how to put them right

• Assuming an increase in aggregate demand always causes inflation.

  Put it right: Inflation only occurs if there is insufficient spare capacity in the economy to absorb the increased demand.

• Ignoring how changes in aggregate demand affect the balance of payments.

  Put it right: Higher aggregate demand usually increases the marginal propensity to import, which can worsen the current account.

• Confusing shifts in aggregate demand with shifts in aggregate supply by attributing changes in production costs to demand shifts.

  Put it right: Aggregate demand shifts are caused by changes in consumption, investment, government spending, or net exports.

Exam tips

• Always use an aggregate demand and aggregate supply diagram to illustrate the impact of changing demand on the price level and real GDP.
• Evaluate the impact of an aggregate demand shift by referencing the shape of the aggregate supply curve and the current level of spare capacity in the economy.
• Discuss trade-offs between macroeconomic objectives, such as the conflict between achieving economic growth and maintaining low inflation, when analysing demand-side changes.