Equilibrium in the As/Ad Framework - Essay Example

The principle upon which the entire of economics is based is the demand and supply. The demand and supply is the fundamental part of economicsand this concept is related to the other principles and concepts of this discipline. When we talk about the aggregate demand and aggregate supply, we are actually referring to the macro economics which takes into consideration an entire economy and not just a single firm or industry. The shape of the aggregate demand and aggregate supply curves is an indicator of the equilibrium in the economy and how the economy would react to major influencers such as the inflation rates and monetary policy, including the money supply. In the diagram given on the right, the aggregate demand curve, the short run aggregate supply curves, and the long run aggregate supply curves are displayed (Crawfords World)1. The slopes of the short run aggregate supply curve and the aggregate demand are very important to estimate the short run influence on the economy as result of any of the major influencing factors of the GDP or Gross Domestic Product. The X-axis which is stated as the natural rate of output is actually the gross domestic product of the economy. When the short run aggregate supply curve (SRAS) and aggregate demand curve (AD) shift, they also change the equilibrium point and may also affect the GDP or the price level in the economy. The point where the LRAS, SRAS and AD intersect forms the long run equilibrium in the economy as is shown in the diagram Figure 1. Since the aggregate supply curves and aggregate demand curves are influenced by the market forces, the real GDP is usually not the same as the potential GDP, but the fluctuation would usually not be a large one and there may be only a small variation. INFLATION Inflation is when the general prices of the goods and services in an economy are increasing. Due to the rise in the prices, it has a negative effect on the purchasing power of the money in the economy. Such is because the people can buy a lesser quantity of goods and services with the same amount of money compared to the last year. The rate of inflation is calculated by the Consumer Price Index (CPI) which is calculated by the increase in prices of all the goods and services in the economy. There are two types of inflation which are anticipated and unanticipated inflation, and both of them create a different impact on the economy (tutor2u)2. Anticipated Inflation: Anticipated inflation is when the inflation rate can be correctly calculated and the people can protect themselves from its effects. An example of anticipated inflation and protect oneself from it is when the labor union collectively bargains for a wage rise in order to keep the real wages at the same level. They are able to bargain because they are aware of the inflation rate and keep in accordance with it (CTAAR)3. Unanticipated Inflation: The truth is that the inflation rates can never be predicted to an exact level and the actual interest rate may usually vary to the calculated inflation rate. This variance is called the unanticipated inflation rate, and it exists because the inflation rates are very volatile from year to year and therefore it becomes difficult to correctly predict the rate. Since it is unknown, the people cannot protect themselves from it. Inflation is caused by cost push and demand pull factors. Cost push inflation is when the rise in prices occurs due to the rise in prices of the raw materials. When the prices of the raw materials increase, the aggregate supply in the economy decreases and the curve shifts to the left. With the aggregate demand curve unchanged, the equilibrium point changes and the inflation rates rise in the economy. This is shown in the diagram on the right where an inside shift in aggregate supply curve resulted in the rise in inflation rates. Another type of inflation is the demand pull inflation which is caused by an increase in the demand of the goods and services in the economy. This is shown in the diagram on the right where it is shown that due to an increase in the demand in the economy, the aggregate demand curve shifts outside and with the aggregate supply curve unchanged, the changed equilibrium causes the inflation rates to rise. Inflation can have a number of disadvantages as well as some advantages, although inflation is generally considered to be damaging for the economy. Inflation can have some advantages over the economy because it is in times of controlled inflation that the businesses experience growth and there is more investment which is very helpful for the economy. Also the stock prices and the value of assets are on a rise during the times of controlled inflation. Such is because there is more investment in the assets in the economy and the stocks which increases the demand of both and results in an increase in their prices (Qwoter)4. Although the unemployment rate in UK has been on a rise which has reached 7.8% in the last quarter, the inflation rate has decreased to 2.7%. The Bank of England has focused on the monetary policies to keep the inflation rates under control and it has managed successfully to keep it just above its target of 2% (Trading Economics)5. Stagflation can have a major negative impact on the economy because it results in the damage to confidence of the investors and the unemployed people face the added difficulty of decreasing purchasing power of money. Effects of GDP Factors on Aggregate Supply and Aggregate Demand Curves Interest rates usually tend to have an inverse relationship with consumption, investment and aggregate demand. As illustrated in the diagram above when the money supply in the economy increases, the interest rates go down. This is because the money is now more easily available to borrow. When the interest rates decline, the investments in the economy increase. This is so because the cost of borrowing is now low therefore new industries can be setup with easy and cheap financing. Also now that the local investors are getting a low yield on savings, they instead choose to invest the money to get a higher yield. When investments are on a rise, the aggregate demand increases. This is so because investment leads to more quantity of better quality products at cheaper prices and since the interest rate is low, people choose to consume rather than save (College)6. A rise in the interest rate would decrease the inflation rate but increase the unemployment rate. The inflation rate would decrease if the type of inflation is demand pull inflation because when the interest rates increase, the aggregate demand reduces and therefore the inflation would decrease. As the aggregate demand of the economy decreases, the production process will reduce and the demand for labor will reduce leading to increased unemployment (Fuentes)7. Business Cycle The diagram on the right shows a typical business cycle (Dinesh Bakshi)8. The business cycle represents a fluctuating economic activity in a particular economy. The historical trends have proven that an economy never goes in the same direction with unchanged magnitude over long periods of time. The economy will go through several stages over a period of time which are termed as expansion, peak, recession, trough (or slump), and recovery (Investopedia)9. The diagram on the right shows the changes in the real GDP rates in the United Kingdom (Riley)10. The diagram shows that the UK economy was going a period of peak in the late 1990’s and the year 2000 when the growth rates started to decline with the start of the current millennium. This period will be stated as the contraction period or recession. The year 2009 was when the UK economy went into a slump at its lowest point and growth rates went into the negative region up to -5%. However, we have seen that in the last few quarters that in the year 2012, the economic growth rates have started to rise again maybe due to the Olympic Games in London and we can state this period as the expansion period or recovery. Conclusion The aggregate supply and aggregate demand curves determine the output in the economy which can also be stated as the GDP or Gross Domestic Product. These curves are influenced by factors such as government spending, investments, personal consumption, and money supply. They add up to form the GDP and influence the aggregate demand and aggregate supply in an economy and the equilibrium point of both these curves in turn determines the GDP and the price levels in the economy. The business cycle can termed as the variations of economic activity in an economy. We have seen that the United Kingdom economy is going through a stage of recovery after it suffered a slump in the year 2009 when the worldwide economies experienced recession. If the economic policies continue and the worldwide economies are also favorable, then the UK economy will continue to rise economically. Works Cited College, Harper. Monetary Policy. . Crawfords World. Aggregate Demand and Aggregate Supply. . CTAAR. Inflation. . Dinesh Bakshi. Business Cycle. . Fuentes, Gilberto. The Effect of Interest Rates on Inflation & Unemployment. . Investopedia. Business Cycle. . Qwoter. Benefits of Inflation. . Riley, Geoff. Understanding the Economic Cycle. . Trading Economics. Indicators for United Kingdom. . tutor2u. Macroeconomics - Consequences of Inflation. . Read More