Nicole Bostan Economics HLMarch 20

Evaluate the extent to which an increase in aggregate demand is beneficial for an economy. (15 marks)

In microeconomics, demand for a product reflects the willingness and ability of consumers to buy a product at different prices, over a particular time period. In macroeconomics, aggregate demand reflects the total spending of all possible buyers (consumers, businesses, government and foreigners) on goods and services in a period of time at a given price level. In macroeconomics, the horizontal axis measures the quantity of total output, or real GDP of an economy, but real GDP, also represents the total income of an economy. Macroeconomics means considering the whole economy together with the demand for all goods and services. The main factors affecting aggregate demand are a change in consumption, investment, government spending, exports and imports. Higher economic growth will lead to an increase in demand for labor, as firms will be producing more. Therefore unemployment will fall, this has various advantages such as lower government spending on benefits and less social problems. However economic growth has various costs. Firstly if economic growth is unsustainable and is higher than the long run trend rate inflation is likely to occur. However, if growth is increased through increasing the productive capacity and increasing the long run trend rate then inflation will not occur and the growth will be sustainable.Short run aggregate supply is the time period when the prices of factors of production do not change and the wage rate is fixed. At any given prices, industries will supply a certain level of output. On the other hand, long run aggregate supply is divided into two different categories the classical where there is very minimum government intervention in the allocation of resources in the economy and Keynesian where the belief is that the government should intervene in the economy with different supply side and demand side policies.In macroeconomics there are two perspectives, precisely the classical and the Keynesian. Furthermore, whether it is beneficial an increase in aggregate demand depends on where the economy stands in terms of the long run, whether there is an inflationary or deflationary gap in two different perspectives, classical or Keynesian and the impact of the multiplier effect.In the monetarist/new classical perspective, the economy is seen as a stable system that automatically tends towards long-run equilibrium where there is full employment at the natural rate of unemployment. This argument has important implications for the short-term fluctuations of the business cycle and long-term economic growth. Since short-term fluctuations (recessionary and inflationary gaps) correct themselves automatically, there is no need for the government to do anything to correct them. Instead, the government must ensure that markets work as competitively as possible, so that all resource and product prices are able to rise or fall as required to allow the economy to settle at its point of long-run equilibrium, at the level of potential GDP. When it comes to promoting economic growth, aggregate demand cannot affect real GDP over the long run. If aggregate demand increases, it will only result in increasing price levels and inflation. Governments should therefore concentrate on policies that affect the supply side of the economy, which attempt to shift the LRAS curve to the right, with the objective of increasing real GDP without causing inflation. Thus, in the classical perspective an aggregate demand increase is not beneficial, only creating inflationary pressure, as seen in the adjacent graph, where AD increased from AD1 to AD2, increasing the Price level and creating the inflationary gap between the AD curve and the long run supply curve. In the short run, it creates pressure and higher prices decreasing consumption, and increasing unemployment, and an increase in the short run supply curve can be beneficial, the economy staying at the equilibrium at full employment of factors of production. Thus a good alternative would be through supply side shocks, which include a change in wage rates, in cost of raw materials, in price of imports and government indirect taxes or subsidies. In the case of an increase in aggregate demand, which creates inflation, an increase in SRAS is eminent. This can be a solution for the inflationary pressure that the increase in AD can create, as seen in the next diagram, where SRAS shifts to the right from SRAS1 to 2 to a new equilibrium price level at P3. Moreover, increasing national income without creating inflation is possible through shifts of LRAS, which can be interventionist or market-based. In a market-based economy, as in the classical perspective, markets operate more freely and this increases incentives for labor to work harder and more productively and also for firms to invest and to increase productivity. Institutional changes affect structures, institutions and rules that govern stakeholders. Some market based supply side policies could be reduction of household income taxes, reduction in corporate taxes, labor market reforms privatization and policies to increase competition. For instance, if income taxes are decreased there is no more paying more taxes for working more, creating an incentive to work, thus more productive, resulting in an increase in national output. This is seen in the next diagram LRAS shifting from LRAS1 to 2, leading to a decrease in price P1 to P2 and increase in full employment level from Yf1 to Yf2, thus beneficial for the overall economy.In the Keynesian perspective, the economy is an unstable system because of repeating short-term fluctuations that cannot automatically correct themselves. Such fluctuations arise mainly due to changes in aggregate demand caused by spontaneous actions of firms and consumers. In the Keynesian view, when there is a recessionarygap, there are many factors preventing the operation of market forces, and so wages and product prices do notfall easily even over long periods of time. This meansthe economy can remain in a less than full employment equilibrium (recessionary gap) for long periods. Therefore, there is an important role for government policy to play to restore full employment and raise real GDP to the level of potential GDP. Governments should focus on policies that increase aggregate demand when there is a recessionary gap, and decrease aggregate demand when there is an inflationary gap, both illustrated in the adjacent diagrams.Policies to influence aggregate demand are particularly important when aggregate demand is low. Demand side policies are advisable in the case of a recession or deflationary gap, including fiscal and monetary policies to affect aggregate demand. By applying fiscal policy the government lowers income taxes increasing consumption or lower corporate taxes and encourage investment. By applying a monetary policy the government is able to reduce interest rate, increasing consumption and investment as a result, both being a component of aggregate demand. The increase in aggregate demand is seen in the next diagram, where there was a deflationary gap at the beginning and after the change in AD from AD 2 to AD3, the real output got closer to full employment Y2 to Yf, showing a smaller deflationary gap. On the other hand, when there is an inflationary gap, AD is at full employment but the high price level, due to a boom in economy can abruptly lead to a recession, thus supply side policies are necessary. These are called interventionist as the government intervenes directly in the economy as according to the Keynesian theory. The government could increase potential output in the economy by increasing investment in human capital, in research and development, in maintenance of infrastructure and direct support for businesses. In essence these could be provided by the market-based system, but they would be underprovided. At the same time, government spending is an aggregate demand component, thus increasing it, would increase AD. This is shown in the next diagram where LRAS has shifted to the right from LRAS1 to 2, decreasing the inflationary pressure and the price level from P1 to P2, at full employment.Furthermore, in the monetarist/new classical model, increases in aggregate demand always lead to increases in the price level, and for this reason in this model it is never possible for real GDP to increase by the full amount of the increase in AD. The multiplier is based on Keynesian thinking, which emphasizes the point that when an economy is in a recessionary gap, unemployed resources and spare capacity allow aggregate demand to increase without putting an upward pressure on the price level. In this situation, any autonomous increase in spending leads to a substantially larger increase in real GDP. Therefore, when we use the multiplier to calculate the effects on real GDP of a change in autonomous spending, we are presupposing a constant price level. However, when a government increases their spending, the final increase in AD will be much greater than the amount of spending, resulting in a proportionally larger increase in national income. As people receive shares of the income and spend it partly, the injections are multiplied through the economy. If a government is trying to intervene to try to fill a deflationary gap, they should consider the multiplier effect, estimating the gap between equilibrium output and full employment, and estimating the value of the multiplier. If the value isnt calculated correctly, it might result in a bigger increase in AD than expected, leading to inflationary gap, as seen in the next diagram, where AD increases from AD1 to 2 due to demand side policies and the price level rises above the equilibrium with the full employment.