Keynesian Dynamics and the Wage-Price Spiral - Coursework Example

Lecturer Paper Aggregate demand and aggregate supply is delineated as a macroeconomic model explaining output and price levels throughout the aggregate supply and demand. The concept of AD-AS was first introduced by John Maynard Keynes. Natural level of production refers to a situation whereby an economy’s resources are fully employed in producing the desired output. At any point of the economy, the price level and real GDP are calculated from the short run aggregate supply curves and aggregate demand. At any point when the level of production is far below the natural level, real Gross Domestic Product will be below its potential. At this point the short run aggregate supply curves and the aggregate demand will intersect on the left hand side. When real GDP is less than its potential, there will be a gap between real GDP and the potential output is referred to as recessionary gap. (Colander,6) In the event that employment is way below the natural level as shown in the first diagram A, it is clear that the total output will be below the potential. As the economy is producing the output below its natural level, it is likely that the level of unemployment amongst the populace will upsurge. Diagram b represents the recessionary gap Yp –Y1 which takes place when the AD curve and the SRAS intersect on the left hand side to the left side of the LRAS. An economy facing a deflationary effect will not remain this situation forever. When markets are working perfectly, the aggregate supply will adjust back to the natural level through price adjustments. As explained above, the aggregate demand will shift in response to any investment, consumption, net exports and government purchases in the economy. In the short run, the aggregate supply will shift to respond to changes in the prices of various factors of production, technology and also to the quantity to the factors of production. This section will discuss how an economy can adjust to a shift in the short run aggregate supply and aggregate demand using changes in government purchases and adjustments in the healthcare costs. (Gillman, 34) Changes in the Government purchases- shift in the aggregate demand In the above diagram, assume that an economy’s initial equilibrium is at point YP. Since the economy is at its full output, the labour that the market offers must be at equilibrium, meaning that the quantity of labour demanded and supplied are equal. Now, assume again that there is an increase in the demand as a result of investment, consumption, net exports or government purchases increased at process level; as shown in the diagram; the aggregate demand will shift from point AD2 to AD2. This adjustment will then result to an upsurge in the Gross Domestic Product to point Y2. The price levels will then be forced to move to point P2 in the short run. An increase in the price levels intertwined with a fixed nominal wage will result into a lower real wage. Firms will be forced to employ more workers to respond to the need to supply the required output. At point Y2 in the above diagram, the economy’s new production is more than the potential output. Employment at this point will exceed its natural level. Therefore, equilibrium in the economy at point P2 and Y2 is only sustainable in the short run. Given that the real Gross Domestic Product is more than the natural level, a pressure will be exerted on the prices to rise. As a result of this pressure, there will be an upsurge in the nominal wages struggle to restore the purchasing power. The rise in the nominal wages will cause the short run aggregate curve to also shift on the left hand side. This shift will not stop as nominal wages to continue rising in price. It should also be noted that as long as there is the inflationary gap, there will be a rise in the nominal wage. A continuous shift in the short run in the SRAS will lead to a reduction in the GDP and therefore the gap begins to close. When SRAS reaches point SRAS2 the economy shall have normalized to pits potential output and employment will have also resumed to its normal level. The adjustments will help in closing the inflationary gap. An upsurge in the healthcare costs- shift in the Short Run Aggregate supply At ceteris peribus, assume that the aggregate demand curve at point AD1 and at the SRAS1, an economy will be at equilibrium when the output YP and when the price is at point P1. Assume again that SRAS shifts as a result of the rise in the cost of healthcare. Given that health insurance premiums are catered for by the company on behalf of its employees, any increase in the premiums paid will result into an increase in the cost of production resulting into a reduction in the SRAS from SRAS1 to SRAS2. Price levels will then rise from point P2 and real GDP reduces to Y2. The difference between Y2 and P2 is the recessionary gap. Given that GDP will be low its potential, prices will be forced to fall. Persistent upsurge in unemployment will also exert pressure on the nominal wages. In the long run SRAS shifts to SRAS1 making GDP to move back to its potential Yp and P1 with employment returning to its original level. (Redwood, 25) Use of Fiscal and Monetary Policy Fiscal policy is the changing levels of aggregate demand and level of economic performance through taxation and government spending. As above, a fiscal expansionary policy shifts AD to AD2 so as to close the gap. In the second diagram, the economy has inflationary gap and therefore the contractionary policy will reduce AD to AD2 to close the gap. (Asada, et al 71) Monetary policy, Expansionary As above, to correct the imbalance through expansionary, the government through federal banks will increase money supply which will then result into reduced interest rate. This will then cause investments to upsurge which causes an increase in aggregate demand. An increase in demand will result into an upsurge in the real Gross Domestic Product resulting into a reduction into unemployment and an increase in price levels. This in turn will result into little inflation which is healthy for the economic growth. (Palley, 29) Contractionary monetary policy As shown in the above, when money supply decreases, there will be a resultant increase in the interest rates. This will result in the decrease in investments opportunities resulting into a decrease in AD with a decrease in the price levels. This will result into a reduced inflation and at the same time GDP will increase causing unemployment to go up. (Chiarella, Peter, and Willi 21) The Economy of UK From the tale, between 1948 and 1973, the GDP of UK has been growing consistely. There were a number of contractions on quatertly basis and the economy was perfoming below its potential. From 1973, there has been a myriad of incidences where the economy faced contraction. These occurred between 1974/ 1981/1999 and 2008 where the global market faced economic meltdown. The contraction in 2008 was the most pronounced GDP the country ever faced. The countries output reduced by 1.6% . The output during 2009/2009 economic meltdown remained at 3.2% below its original peak. It took the economy more than 22 quarters to be back to its peak again. For the economy to retun to this peak, the government adopted both fiscal and monetary policy to help in stabilizing the economy. The overnment through its central bank reduced the lending rates to increase the level of production by firms with subsequest creation of job opportuinities. The government also enhanced the level of its expenditure with reduced government taxes imposed on firms. Works Cited Asada, Toichiro, et al. Keynesian Dynamics and the Wage-Price Spiral: A Baseline Disequilibrium Model. Rochester: Social Science Research Network, 2005. ProQuest. Web. 6 Dec. 2014. Chiarella, Carl, Peter Flaschel, and Willi Semmler. Price Flexibility and Debt Dynamics in a High Order AS-AD Model. Rochester: Social Science Research Network, 2006. ProQuest. Web. 6 Dec. 2014. Colander, David. "The Stories we Tell: A Reconsideration of AS/AD Analysis." The Journal of Economic Perspectives (1986-1998)9.3 (1995): 169. ProQuest. Web. 6 Dec. 2014. Gillman, Max. AS-AD in the Standard Dynamic Neoclassical Model: Business Cycles and Growth Trends. Rochester: Social Science Research Network, 2012. ProQuest. Web. 6 Dec. 2014. Palley, Thomas I. "Keynesian Theory and AS/AD Analysis." Eastern Economic Journal 23.4 (1997): 459-68. ProQuest. Web. 6 Dec. 2014. Redwood, John. "Shock UK GDP Figures could be a Game Changer." Investment Week (2011): 13. ProQuest. Web. 6 Dec. 2014. Read More