In economics, aggregate demand measures the total demand for final products in an economy at a given price level and time. This includes the quantity of goods and services bought by purchasers at the prevailing price level. Aggregate demand curve gives the summation of an individual demand curves for different economy sectors. The equation below gives the function as a linear equation of variables.
AD is the aggregate demand
C represents consumption. It is normally written as ac + bc(Y-T).
I represent the investment
G represents government spending.
NX = X-M is the Net export
X is the total exports
M represents total imports and can take the form of am + bm (Y-T)
Aggregate demand is a vital concept introduced by John Maynard Keynes. It still holds most of the macroeconomics theories that explain the overall determination the level of employment in a country. In his explanation, Keynes highlighted the connection between varieties of quantities of a good purchased by a consumer with different prices using the demand schedule. Keynes observed these behaviors and came up with the explanation behind aggregate demand. In this chapter, the writer will focus on the explanation behind the insufficient aggregate demand that Keynes brought out. This will contain an explanation on the suggestions by Keynesian economists on how to solve the problem of insufficient aggregate demand. A further analysis will focus on the limitations to the applicability of Keynesian economic policies by other critics in the field of economics (Kalecki, 2007).
Keynesian economics is an economic theory behind John Maynard Keynes between 1883 and 1946. He is prominent through his explanation of the cause of the great depression that affected the world economic climate, leading to a lag in the economic upraise. Keynes economic theory based its arguments on a circular flow of money. It relates the expenditure of one person to another person’s income in a circular motion. This is a circle that continues round and round throughout the economy. That is when one person spends; the expenditure forms an income to another person. This will then rotate and become a source of income to the first person. This will continue forming a circle. In Keynes study during the event of the great depression, he discovered that, during this time, the natural reaction of people is to hoard money. In Keynes theory, the hoarding of money stops the circular flow of money thus keeping the economy at a standstill. It is with this reason that Keynes suggested the involvement of the government to increase spending. This is possible through an increase in money supply or by the government literally buying things on the market (Paul and Baran, 1968).
In an economy with instability in aggregate demand, there is the problem of the great depression. This is an instance of what occurred in the United States. To most economists, insufficient aggregate demand comes in because of collapse in investment. Investment down pour reduces the output of an economy leading to a reduced aggregate demand. Other causes of insufficient aggregate demand include stock market crush that reduces the wealth of some few individuals. This will further reduce the consumption formula of a consumer thus shifting the aggregated demand curve to the left. Fiscal policy to a greater extends brings about insufficient aggregate demand. If consumption and income falls, the government finds it hard to tax the individuals thus reducing the revenue of the government. Many factors contribute to the insufficiency in aggregate demand. It is with this reason that Keynesian economists suggested ways of handling the matter (Yates, 2003).
Equilibrium in the financial system rests in the level of full employment of gross national income. Sometimes, during the short run, fluctuations can make the economy unstable. This affects labor side thus opting out of employment pattern. Keynes view on the same highlighted that aggregate demand determines the output of an economy. This in the end affects the demand for labor. Keynes challenged the fact that the problem of instability is not connected to labor supply. In fact, a country can experience long-term equilibrium with insufficient aggregate demand causing full employment. All this is explained in the Keynesian economics theory. It highlights the total expenditure in the financial system also called the aggregate demand. In the case of insufficient aggregate demand, Keynesian suggested the use of government involvement in solving the problem of aggregate demand. This involves the use of fiscal policy through raise of government expenditure to raise aggregate demand. The involvement of government expenditure has an effect on the aggregate demand, output, and employment especially when the economy is operating below full capacity with reference to the national output. In the process of the government acting on the same, it has to use budget surplus to do the following:
To slow the pace of the significant economic growth
To make the prices stable in times of high inflation
The theory of Keynesian economics suggests that by removing the spending from the economy, the levels of aggregate demand will reduce leading to stabilization of prices (Mayhew, 2009).
How fiscal policy affects demand
In analyzing the effects of fiscal policy, changes on government expenditure and tax on equilibrium output take effect. In the analysis of this effect, economists use the IS LM concept to explain the effect of government spending on the output of a country. The changes in the fiscal policy will affect the IS curve thus changing the equilibrium output demand and the interest rates. Supposing that with the initial level of government purchases and tax schedule, the resulting output level is below the full employment. This means that there is a lot of unemployment in the economy. The objectives of fiscal policy in this case will be to increase demand through an increase in government spending or a reduction in tax rate (Sherman, Hunt, Nesiba, and Ohara, 2008).
The effects of an increase in government expenditure on output: An increase in government expenditure adds directly to the output of the economy through the multiplier effect. This increases the output level of the country. The increase in output causes the excess demand in the money market thereby causing an increase in the interest rates. Relative increase in the interest rates causes the investment in the economy to fall and through the multiplier effect, the economy settles at equilibrium (Paul and Baran, 1968).
Effects of a tax cut on the output of a country: Permanently reduction in tax rates increases the aggregate demand of the economy. A reduction of tax from the consumer bundles increases the income of people. This in the end boosts their purchasing power that relates to the excess of aggregate demand in the money market. This will then force the interest rates to rise again. The increase in interest rates reduces investment but through the multiplier effect, the economy settles at equilibrium (Sherman, Hunt, Nesiba, and Ohara, 2008).
Most of the economists have debates on the effectiveness of the fiscal stimulus. The statement that brings contention surrounds the crowding out effect. This is a situation where the government activity in stabilizing the economy leads to higher interests rates thus offsetting the stimulative impact of spending. The Keynesian view, fiscal stimulus has the best solution to deficiency in aggregate demand and that the problem of crowding out effect is minimal with the existence of a liquidity trap.
Do you see any limitations to the applicability of Keynesian economic policies?
The theory of Keynesian on economics, also called the demand side economics, gives emphasis to the significance of aggregate demand in the economy. In the 1930s, Keynes suggested the involvement of government spending to boost total demand. This happened after the great depression that gripped most parts of the world. Keynes urged various states to raise output through the government expenditure to stabilize the economy. However, critics have issues with the demand side of economics regarding the suggestion of Keynes (Sherman, Hunt, Nesiba, and Ohara, 2008).
First is the problem of inflation. This is the main problem in the demand side economics. In the context of the demand side, the market economy on itself will not ensure adequate demand in the economy. In this scenario, the forces will not divert the economy to stabilize on its own unless acted upon by an outward force. This outward force is the government to step in and ensure sufficient adequate demand together with full employment with fiscal policy. This is not the case with the real scenario since higher government spending gives an excessive stimulus to the economy. This in the end raises the prices of consumers. This gives the central bank an extra task to ensure interests rates hike. An increase in the rates makes it hard for consumers to obtain loans for large purchases. In addition, it burrs the ability of companies to borrow money from the lending institution. This is the crowding out effect.
Budget deficit is yet another issue that raises eyebrows on the demand side of economics. During the time of recession, output declines incredibly due to reduced activity. The involvement of the government to compensate for the reduced rate of aggregate demand comes from the finances borrowed. This increases the government deficits thus raising the national debts. Funds for offsetting the national debts need to come from the government budget. This will bring issues in the long run since the amount allocated for payments may be useful in crucial projects in the society. The allocation of resources may delay due to the repayment process and the productive activities like education and infrastructure may delay. An adverse effect captures the economy especially if the economy refuses to pick up. It is the worst way of solving an economic crisis.
Sometimes in the event of solving issues to do with aggregate demand, some policies implemented may lag due to lack of funds. Under the Keynesian economics, the involvement of the government should ensure stable aggregate demand. Excessive demand leads to rise in inflation whereas insufficient demand causes higher unemployment. It is with this reason that the demand side economics needs frequent government intervention like reducing the spending patterns in a healthy economy while increasing spending in the weaker periods. This brings some doubts concerning the demand side and the implementation of policies. It is difficult to realize the time when the government should act on a certain policy implemented. Under normal circumstances, the policy-making process is accountable for the impediment in the adoption and implementation process. Furthermore, there is a lag between the effects resulting from the policy implemented and the policy itself. This may lead to a long duration of time in the process of changing the government economic policy and the effect of policy on the economy.