The Study of Aggregate Demand - Essay Example

The economy is said to progressing when the several factors such as inflation and unemployment are under control and at low levels. Inflation is whenon general, the prices of the goods and services in the economy are increasing. This means that inflation results in a decrease in the real purchasing power of money as compared to what could be bought in the last financial period (Investopedia, n.d.). Opposite to this is deflation which exists when the inflation rates are in negative range. This means that the prices of the goods and services in an economy are generally decreasing and the purchasing power of money is on a rise. To understand the concept of inflation and deflation, it is necessary to understand the aggregate demand and aggregate supply. Aggregate demand is said to be the total demand of the Gross Domestic Product (GDP) of an economy and its components are the consumption (C), investment (I), government expenditure (G), and net exports (X-M) which is the imports subtracted from exports (Investopedia, n.d.). Along with aggregate demand, there is the aggregate supply which is the total supply of the Gross Domestic Product and it is the total of the goods and services produced in the economy. The diagram on the right shows the aggregate demand and aggregate supply curve which help to signify the inflation rates and the GDP in the economy. Inflation rates are calculated by different measures which are namely the Consumer Price Index (CPI), Retail Price Index (RPI), and RPIX. Consumer Price Index (CPI) is used to measure the price level of the consumer goods and services in the economy. Retail Price Index (RPI) is the measure of inflation by measuring the change in the prices of retail goods and services. RPIX is a measure which is dominantly used in the United Kingdom and it is the RPI excluding mortgage interest payments. The Bank of England has set a target of an inflation rate of 2% which is considered to be ideal given the circumstances of the UK economy. The inflation rate of 2% is low and very much constant which means that there is stability in the economy. The UK also has set the golden rule which is that the government will only borrow the money in order to invest and not to fulfill the current spending in the economy. This means that the economy will not be leveraged to a greater level to cover the expenses, and money will be borrowed to generate future revenues. The Bank of England works to keep the economy stable and head towards progress, with the help of its fiscal and monetary policies. The Bank of England aims to keep the inflation rates at low and constant level which generates investor and consumers’ confidence and it will help to develop the economy in the present as well as in the future. The figure on the right shows a business cycle which represents the points which can be experienced by an economy, both good and bad. The peak is the point when the economy is doing its best and economic growth rates are high. At this point, the unemployment rates are on a low but the inflation rates may be high. During the recessionary period, the economy is experiencing lower economic growth and unemployment starts to rise but inflation may or may not be decreasing. The time of trough or slump is when the economy is at its worst in that time and such economy usually faces high unemployment rates and low inflation rates. However once again, the inflation rates may or may not be decreasing as it depends on several other factors too. Inflation can be of two types according to their predictability, which are the anticipated and unanticipated inflation. Anticipated Inflation: Inflation is said to be anticipated when it can be accurately predicted and that it is foreseen to be at a specific level in a financial period. Since this inflation is calculated and known, people can protect themselves from its impact. An example of anticipated inflation is when a labor union collectively bargains for a rise in their wages because they have anticipated the inflation rates and they want to maintain their real wages. Anticipated inflation has two costs which include the shoe leather cost and menu cost. The shoe leather cost is the opportunity cost of the time needed to calculate the inflation and depositing and withdrawing cash from banks to protect one from inflation. Menu costs, however, is the cost of revising the prices again and again as a result of anticipated inflation. Unanticipated Inflation: On the other hand is the unanticipated inflation which is when the actual inflation rate differs from the anticipated inflation rate. Since the inflation rates are so volatile, it makes very difficult to calculate them accurately and this results in unanticipated inflation. It is also the result of several unforeseen factors, for example if there is an earthquake, then the demand for pharmaceutical products rises and the increase in aggregate demand results in the rise of the inflation rates. The diagram above shows a shift of the aggregate demand curve on the right as a result of an increase in the consumption of the good and this result in the rise in inflation rates. Unanticipated inflation can benefit the government and people in different ways. During unanticipated inflation, debtors gains and creditors lose and therefore the real value of money gets transferred resulting in redistribution of wealth and income. It can also benefit the government because the government is a large debtor and therefore it will have to repay less amount of money in the future (Pirayoff, 2004). On the other hand, unanticipated inflation also results in costs to some groups. People who have fixed incomes suffer because their fixed incomes now have lesser purchasing power as compared to the past. Similarly, people who have saved their money will lose if the interest they get is less than the inflation rates. Also, the creditors will lose because the money that they will get will have less real value and therefore less purchasing power. Unanticipated inflation also causes the money illusion which is when people tend to get confused between the real and nominal value of money. The wage of a worker may increase by 5% but if the inflation rate is also 5%, then the worker is only experiencing a nominal rise in wages and unchanged real wage. Levels of Inflation There are several types of inflation which can be classified as controlled and uncontrolled inflation. The first type of uncontrolled inflation is stagflation, which is used when an economy is going through a period of increasing inflation rates as well as unemployment rates. This means that the economy as a whole is going back but the prices are still increasing (Investopedia, n.d.). During the recent past and present, several economies are facing this problem, and if it is not solved quickly, then it can damage the economy quite badly. The second type of uncontrolled inflation is hyperinflation which is very high and sustained rise in the inflation rates. There is no numerical value fixed to this concept but it is considered very dangerous for the economy. An economy which is going through hyperinflation is Zimbabwe who has experienced extremely high rates of inflation. This inflation is caused by two types of factors which are the cost-push and demand-pull factors. When the price increase in raw materials results in the increase in prices of the goods and services, then it is said to be cost-push inflation. When the prices of raw materials rise, the profit margin of the producers decrease and they try to reduce their supply. When such happens, the aggregate supply curve shifts to the left causing the equilibrium to go at a higher point and thus cost-push inflation. This is shown in the diagram on the right where SRAS1 has caused a higher inflation rate. An example of cost-push inflation is when the oil prices increased drastically, then the prices of a lot of other products also went up because oil is used as a raw material as well as for transportation purposes. The other type of inflation is the demand-pull inflation which is caused by an increase in the aggregate demand in the economy. When the demand in the economy rises as a result of different factors such as a population rise, then it puts pressure on the unchanged aggregate supply and therefore the price increases (Moffatt, n.d.). The diagram on the right shows that an increase in the aggregate demand causes the demand curve to shift to the right. With an unchanged aggregate supply, the equilibrium point rises and this result in a higher inflation rates. Deflation: The potentially worst type of inflation, however, is deflation which is when the inflation rate has a negative value and the prices of goods and services are generally decreasing. If the deflation is caused by an increase in the aggregate supply, then it is not damaging for the economy. However, if deflation is caused by a reduction in the money supply, then it is very harmful for the economy. In the diagram above, the increase in aggregate supply and decrease in aggregate demand causes the inflation rates to fall. If it continues to do so, then inflation rate may go into negative value which is deflation. The first major disadvantage of deflation is that it results in lower profit margins, and if it continues to happen, then the businesses eventually opts to close down. Since the deflation is foreseen, people will cease their spending in the present to purchase the same good and service in the future for lower prices. This can actually cripple the economy because the consumption will be very low. The third and last disadvantage is that deflation causes the prices of stocks and assets to fall which damages the confidence of the investor and the investment function of aggregate demand decreases. Thus, deflation can actually turn out to be much worse than inflation. Although it depends on the factors leading to deflation, but as mentioned earlier, if the deflation is caused by reduction in money supply, then it can have long term consequences. The only way to get out of this will be to print more money notes and extra money notes will damage the economy even more because it can lead to hyperinflation instantly. Therefore, it can create a sort of chain reaction with one solution to the problem leading to another problem (Waggoner, 2012). Thus it can be rightly said that deflation is more dangerous than inflation. Conclusion: As the Bank of England has aimed for, a low and positive inflation rate is good for the progression of the economy and adds to its stability. However, it needs to ensure that the inflation rate do not fall to a negative value or deflation as it can have a much worse impact on the economy. Inflation tends to create an impact on the economy usually in the short run, deflation can have long-run impacts on the economy and the central banks certainly do not want this. Gaining the confidence of the investor and consumers to restore the aggregate demand is very difficult and therefore, it needs to be ensured that a scenario of deflation does not occur. Bibliography Investopedia, n.d. Aggregate Demand. [Online] Available at: http://www.investopedia.com/terms/a/aggregatedemand.asp#axzz1pysOnNNS Investopedia, n.d. Inflation Definition. [Online] Available at: http://www.investopedia.com/terms/i/inflation.asp#axzz1pysOnNNS Investopedia, n.d. Stagflation. [Online] Available at: http://www.investopedia.com/terms/s/stagflation.asp Moffatt, M., n.d. About.com Economics. [Online] Available at: http://economics.about.com/cs/money/a/inflation_terms.htm Pirayoff, R., 2004. In: Economics Micro & Macro. s.l.:John Wiley & Sons. Waggoner, J., 2012. Forget inflation: Is deflation the real threat?. [Online] Available at: http://www.usatoday.com/money/markets/story/2012-01-06/deflation-inflation-threat-to-stocks/52457310/1 Read More