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Nicole Bostan

Economics HL
March 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.

Nicole Bostan
Economics HL
March 20
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.

Nicole Bostan
Economics HL
March 20
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 shortterm 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 recessionary
gap, 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

Nicole Bostan
Economics HL
March 20
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.