Aggregate Demand ( Simple Economics )

Hello all,

Part of the aim of my blog was to make Economics and Business accessible for anyone and everyone who doesn't have any experience or education in either field. As such, I will be posting a couple of my early AS Economics essays. Enjoy : )

N.B - Graphs cannot be displayed- Please Google AS/AD Graphs for examples.

Discuss the extent to which an increase in Aggregate Demand (AD) affects output, unemployment, and inflation (18)  

The equilibrium reached by aggregate supply (AS) and aggregate demand (AD) determines several characteristics of an economy, such as output, unemployment, and price  rises ( inflation). An increase in AD can have varying consequences on these, dependent on several factors such as potential increases in AS and the position upon the AS curve that the AD reaches equilibrium with.

At the elastic section of the AS curve, resources are abundant and prices for these resources are low, due to the abundance of supply resulting in a supply/demand disequilibrium. During the elastic part of the AS curve, output is low, due to the low amount of factors of production being utilised. As labour is one of these four factors of production (Land, Labour, Capital, Entrepreneurship), unemployment will be high, again due to the low output meaning less factors of production being utilised.

If AD were to rise during the elastic part of the AS curve, output would increase, as more factors of production would be employed to meet this demand, increasing the economy’s output and hence Gross Domestic Product (GDP). Unemployment would decrease disproportionately, as the cost for labour will be low, due to the supply/demand disequilibrium forcing wages, i.e the price for labour, to be low. Due to these low wages, more people can be employed for the equivalent price as if wages were higher and less people were employed. However, price will remain constant, due to the aforementioned abundance of factors of production meaning that overall cost of production remains low. This can be displayed on the following graph :

 Following the initial increase in AD, the multiplier effect will begin to take effect, due to the circular flow of income. As such, the initial increase in AD will multiply the long term effect on AD, assuming injections are greater than leakages. When injections = leakages, the multiplier effect will not take place, and AD will stop increasing due to the multiplier effect, although other externalities may cause further increases in aggregate demand. The multiplier effect exerted upon the initial increase in AD at the aforementioned elastic AS/AD equilibrium may push AD outwards to meet an equilibrium with the increasingly inelastic section of the AS curve, as demonstrated in the following graph :

 During the period of increased inelasticity, factors of production become more scarce and hence cost more due to the supply/ demand disequilibrium. The increased scarcity of factors of production also means that less efficient factors of production are employed due to the more efficient factors of production having already been allocated. As a result, the cost of production is increased due to the increased cost of factors of production and increasing inefficiency, and this increased cost of production is reflected in the increased price for goods and services. Unemployment decreases, although the aforementioned increase in the cost of labour means that less extra people can be employed relative to the aforementioned AD increase along the elastic part of the Aggregate Supply curve, as shown by the above graph.

If AD was to increase at this point but remain within the increasingly inelastic , and AS was to stay constant, unemployment would decrease as more factors of production would be required to meet this demand, and hence more people would be employed. Price would also rise as there would be greater competition for these factors of production, which would also be more inefficient as the more efficient factors of production will already have been allocated, as aforementioned. Output would rise, due to the increased amount of goods and services sold within the economy and the greater capacity utilisation of the overall economy. This can be demonstrated within the following graph :

 However, if firms believe that the rise in AD will be permanent, they will invest in capital goods, one of the four factors of production, in order to expand their Production Possibility Frontiers (PPFs), hence shifting AS outwards. If AD rises faster than AS, a situation called overheating will occur in the economy, i.e price rises, i.e inflation. Unemployment should decrease, due to the outward shift in aggregate supply, although much of this outward shift will be accounted for by the increased capital, hence unemployment may only decrease by a small amount. Output will also increase, again due to the increased factors of production and demand allowing more goods and services to be created and sold within the economy. This can be shown within the following graph :

 If AD increases as much as AS, price will remain constant due to the increased availability of factors of production meaning that they compete to offer lower prices, keeping cost of production and hence price low. Unemployment will decrease, due to the increased AS meaning improved quality and/or quantity of factors of production, one of which is labour. Output will also rise, again due to the increased factors of production and demand allowing more goods and services to be created and sold within the economy, shown below :

 The final part of the AS curve is the perfectly inelastic section. If AD meets an equilibrium with the AS curve here, output is at it’s maximum amount with the supplied factors of production. As such, unemployment is also at it’s minimum, that is, full employment, which, under the Keynesian school of thought, 3% unemployment. Therefore, at the perfectly inelastic section of the AS curve, an increase in AD will only bring about an increase in price- Output and Unemployment cannot change with the given factors of production, as the economy is already at it’s full output given the factors of production supplied. This can be shown as follows :

To conclude, an increase in AD can alter output, unemployment and price, dependent on the position and potential shift or movement along AS. An increase in AD, can to the fullest extent  influence all three of these indicators, through supply/demand disequilibriums  and the multiplier effect, although the power of the increase in AD is dependent largely on the position and equilibrium met with the AS curve.