Macro & Micro economics of Learning: The aggregate demand curve represents the total quantity of services and goods demanded by a given economy at different price levels. It is calculated by summing up, Consumption, Investment, Government expenditure and Net export earnings. Therefore, if the government was to cut on its expenditure the aggregate demand curve is expected to shift to the left as there will be less investment on major government projects, however, When the government reviews taxes downward investment and consumption by locals and foreign investors is expected to increase.
This translates to shift of the demand curve to the right. This is because with increased investment the economy`s GDP is expected to increase. If these events were to occur simultaneously the demand curve would be expected to shift to the right in the short run as the effects of taxation are more likely to be felt faster than the effects of government expenditure. However, in the long run there may slight shifts towards the original aggregate demand curve as the effects of government spending start to be felt. The recessionary gap represents a situation in which an economy operates below its full – employment hence there is a lower GDP than it would be at full employment.
This situation can be corrected by injecting components that would shift the aggregate demand curve to the right or those that would shift the short run aggregate supply curve downwards up to a level where the long run supply curve meets with the aggregate demand curve. Under this situation the major characteristic realized is unemployment. Therefore, any factor that may correct unemployment will also help reduce this gap.
This may be factors like increased government spending as well as reviewing taxes and interest rates downwards to stimulate investment. The price levels are also expected to fall and this will increase the disposable income. Since there are few goods being chased by too much money the prices will eventually rise (Arnold, 2004). The economy is likely to experience a shortage for its output thus investors will increase the output and by this they will have to employ more labor and eventually unemployment levels will decline.
Thus, with the excess supply but declined demand during self regulation, supply is expected to have a very big gap with demand and eventually prices will decline to P2 from P1 and this will reduce the recessionary gap. The output will also increase from 9 to 10 enabling the economy to work at full employment. (Arnold, 2004) In the case of an expansionary gap where there is inflation in the economy or where the potential GDP output is less than the actual GDP output In most cases it results from application of a monetary policy by the central bank mostly the reduction of interest rates in order to increase consumption (Arnold, 2004).
Any decrease in interest rates allows consumers to have easy access to funds which empowers their purchasing power. This leads to an increased demand of goods and services in that economy and the producers responds by hiking the prices. Therefore during inflation the output is low while the prices are very high. Expansionary gap results in response to excess demand in relation to available supply.
In the figure below if we are to allow self adjustments to rectify the expansionary gap then we would be required to make use of the passive approach. Aggregate supply would reduce as prices continue to rise and this would in turn reduce the purchasing power of the consumers. This approach always results into even higher price levels P2 from P1 but this is corrected by an increase in the wage levels. (Arnold, 2004) In case of an economic boom in the USA accompanied by increased demand for Canadian goods or in other words increased importation, then the output (Y) is expected to fall because the net export earnings will be reduced by the imports while inflation is expected to rise as there will be lower output than expected output.
Prices will increase and this will be rectified as explained above either through government intervention or through self adjustment of the market forces. However in the long run this will be corrected and the economy will be producing at higher levels of output eliminating the inflation (Wessels, 2006). An equivalent decrease in government spending and taxes would have opposite effects in the short run where the reduced government spending will decrease the output levels significantly and this will result in a recessionary gap.
On the other hand decreased taxes will trigger an investment boom as well as increase the disposable income hence consumption. This will increase the output level will result into an inflationary gap the effects of both events happening simultaneously will depend on which factor affects the outcomes faster. However, in the long run the two events may counter each other bring the economy to its previous output level (Wessels, 2006). When the consumers have confidence this translates tom more consumption thus increased aggregate demand level the output levels will thus increase and this may result to excess demand thereby increasing the prices.
Increased prices indicate that the economy is experiencing inflation. This may be short lived as investors will respond to this by increasing their production in the long run thus reducing the inflation and the economy will flourish more i. e. increased output. These responses will therefore aid the economy to self adjust therefore rectifying these shocks (Wessels, 2006). When the wages of workers are increased this will increase their disposable income giving them a higher purchasing power.
Consumption will increase triggering investment as well. This will result to increased output in the economy. Inflation will also increase in the short run as demand will be higher than supply hence prices will increase. However, as investors start to respond to this excess demand situation, prices will fall checking the inflation. Since wages are always rigid downwards, the output levels of the economy will remain high even in the long run (Wessels, 2006). Retirement of a significant portion of the work force would have mixed effects to the output and inflation.
One of the responses is if the workers are sent home with retirement packages, then they will have money to spend thus increasing consumption and investment. With this scenario, the output level would increase and so would the inflation. However, if the workers are laid off without their packages then consumption would reduce thus contracting the economys consumption as well as its output.
Conversely, inflation would be greatly reduced and a recessionary gap would be expected. In The long run however, through government interventions the recessionary gap would be rectified and the government may increase its spending thus bringing back the output levels (Wessels, 2006). Canadian government tightening its monetary policies would make its goods more costly and the exchange rates for both countries would be higher. This would discourage imports thus increasing the net export earnings for USA translating to higher output levels. Supply levels of goods would reduce creating a demand deficit and this would result in an upward rise in prices.
Inflation would result in the short run. In the long run more investments would be noted to compensate for the deficits which would result in increased output levels and inflation would be reduced as well (Wessels, 2006). Investors’ confidence is very important in any given economy as it determines the level of investment and borrowings. These factors are equally important especially in the determination of inflation rates. Reduced investment would contract the output level and result in reduced production of goods and services.
Prices are expected to move upwards thus resulting to increased inflation and this is only to be experienced in the short run. In the long run government expenditure and campaigns to boost the investors’ confidence may revise this situation downwards thereby increasing the output levels while reducing inflation to suitable levels (Wessels, 2006). A significant decline in the stock prices would have the same effect as the decline in the investor’s confidence. Panic selling will result and this may destabilize the value of the local currency.
There will be too much liquid cash available that will make the interest rates to increase. Output will reduce while inflation will increase as there will be more money chasing few goods. The government would in this situation use both the monetary and fiscal policies to rectify the situation and the process would be reversed in the long run i. e. the output would increase as inflation rate is reduced (Wessels, 2006). Increased demand by Canada for imported food would translate to more export earnings in the US as well as increased investment to satisfy this demand.
More borrowings will be experienced and this would result to increase output levels while inflation would be reduced. This will however, be short lived as more investors flood the food industry neglecting other investments. Prices of other goods will increase resulting in a price increase and inflation. Output will therefore start to decline although at a lower rate than inflation. The government would have to invest more on other sectors of the economy as market forces may take long to readjust this situation (Wessels, 2006).
Subsidies towards gasoline would motivate investment and this would stabilize the prices of basic commodities Inflation would not be experienced where as output would be increased significantly. These events will be experienced in the short run but in the long run the situations not likely to adjust with notable impacts as output is expected to remain high whereas inflation will be at its best rates (Wessels, 2006). References Arnold, R. A. (2004). Economics. Boston, Massachusetts: South-Western College Pub. Wessels, W. J. (2006). Economics. New York: Barrons Educational Series.