Aggregate Demand and Economic Growth, Unemployment, Inflation, and Balance of Payment - Essay Example

Running Head: Aggregate Demand Your name Course name Professors’ name Date Introduction This essay covers Aggregate Demand and its relationship with economic growth, unemployment, inflation, and balance of payment. The paper begins with a detailed account of aggregate demand then progresses to illustrate its relationship with some economic objectives. In brief, economic growth is the positive change in output level for country over a specific period whilst unemployment reflects a condition in an economy where individuals who are actively looking for jobs remain unemployed. The economic term inflation describes a perpetual rise in prices of goods and services in an economy over a period of time. Finally, balance of payment which is an account of monetary transactions between countries is explained with reference to aggregate demand. Aggregate demand This is the total amount of goods and services demanded in an economy in a given time period and at a given overall price level (Anderton, 2003). Aggregate demand is usually represented by the aggregate demand curve which shows relationship between price levels and quantity of output that firms are willing to offer. Normally, there is a negative relationship between aggregate demand and the price levels. Aggregate demand is composed of various components including: consumer expenditure on goods and services, Investment spent on capital goods, government spending for example on education, exports and imports of goods and services. These components are represented in the following aggregate demand equation: AD = C+I+G+(X-M) where the extrinsic variables C, I, G, X and M are consumption, investment, government spending, exports and imports respectively (Begg, 2003). The equation is further written as GDP = C(Y - T) + I(r) + G + NX. C, whish represents consumers’ expenditure on goods and services includes demand for consumer durable and non-durables which are consumed thus qualifies to be repurchased. In the UK, consumer spending contributes about 60% of aggregate demand (Easterly, 2002). To determine consumption expenditure, a consumption function to be used is: C= a + (mpc) (Y-T) where “a” is autonomous consumption, “mpc” is the marginal propensity to consume and “Y-T” is the disposable income. Capital investment, I, is the expenditure on capital goods such as machinery and building for the purposes of investment (O'Sullivan, 2003). Working capital including stocks of both finished and unfinished goods is factored as investment. It therefore represents spending aimed at future production of consumables. According to Keynesian model, there is bound to be a decrease in national output and income in a situation of unplanned investment. For this reason, investment is affected by both output and interest rates. In this context, an increasing interest rate leads to a declined aggregated demand. High interest rate means that the cost of borrowing to both households and firms are high as a result cutting back on their spending. The subsequent effect is a lowed equilibrium GDP and a production level which then leads to unemployment following worker lay off. Government spending represented by G, is expenditure on goods and services meant for public comfort. The amount of government expenditure is affected by development projects in an economy and constantly changing political environment. Transfer benefits such as state pension are not included as government expenditure for the simple reason that they not a payment for the any factor of production that leads to specific output. The constituent “X-M” relates to international trade of goods and services between say UK and other countries in the globe. Exports, X is an inflow of demand into a country’s circular flow of Income thus is a positive move. On the contrary, imports given by M are a withdrawal of demand from circular flow of income and spending. This is an outward flow of money as goods and services are purchased for local consumption. Net exports, X-M, is the effect of international trade on the level of aggregate demand. If X-M is negative, the result is a trade deficit while it is a trade surplus when the net export is positive. Aggregate Demand and Economic Growth It is important to understand that a business cycle is a consequence of fluctuation that occurs in an economy due to changes in aggregate demand. These changes emanates from both economic and non-economic reasons. Economic reasons include an action by government to manipulate taxes and the interest rates. Non economic reasons may include drought, natural disasters, and war among others. In a business cycle, increasing growth rate of real GDP takes place during an economic expansion (Helpman, 2004). This eventually reaches the peak stage since growth is usually accompanied by expanding inflation rates. The high prices brought about by inflation leads to policy framework used to regulate inflationary pressures. Recession is the defining part of a business cycle which happens after reaching the peak level. In an attempt to counteract and smooth out the business cycle, both fiscal and monetary policies are used. Briefly, fiscal policy is employed by executive and the legislative branches of government and takes into consideration changes in taxes and government spending (Karras, 1993). Given that consumption depends on disposable income, Y-T, a decrease in T will increase disposable income consequently increasing consumption and ultimateltly GDP. The Federal Reserve may otherwise decide to increase or decrease interest rates with an intention of changing business investment. Falling interest rates lowers the cost of borrowing and motivates people to consume instead of saving. This is an expansionary monetary policy which shifts aggregate demand curve outwardly. Aggregate Demand and Unemployment By referring to Keynes, aggregate demand is affected by both community and personal decisions. The public decisions are mostly those that capture monetary and fiscal policies. Keynes argues that aggregate demand changes impacts on real yield and employment (Keynes, 1936). The economist concluded that unemployment is a result of shortage in demand for commodities and serrvices. To overcome this deficiency, the government is required to adjust own spending. Money supply and interest rates can further be controlled so as to manipulate investment. These adjustments clearly illustrate ability to influence economic cycles through a process of macro-economic fine-tuning. To exemplify how aggregate demand policy creates employment opportunities, it is vital to analyze both monetary and fiscal measures. If money supply is increased, loadable funds would increase whilst interest rates declines consequently favoring increased investment. Investment expands general production thus increase employment opportunities for labor and skills in various categories of the production sector. At the same time, tax cut motivates taxpayers to spend on consumer goods. Production of these consumer goods increases employment opportunities. The concept of multiplier effect further creates more opportunities for people to be employed. Aggregate demand and Inflation Demand-pull inflation occurs where there is an increase in aggregate demand. There are four macroeconomic sectors that affect demand in an economy. These are the households, businesses, governments and the foreign buyers. If these sectors concurrently purchases more output that the economy can produce, it is most likely that they will purchase limited amounts of goods and services. At this point, buyers bid prices up, causing inflation. The situation created that usually occurs in an expanding economy, is that of excess money in circulation. Keynesian theory explains how demand increases with an increasing employment of people. Firms are bound to employ more people in order to give more output when demand is great. Due to constrain in capacity, increasing output will eventually fade and price of goods will rise. Initially, an increasing demand sends a message that more workers are needed. This will then shift the demand to the right with much less being produced compared with the previous period. The price level at this stage will rise to a higher level depicting inflationary trend as illustrated in the graph below. Graphical representation aggregate Demand increasing faster than production (Sexton, 2005) Aggregate demand and Balance of payment According to Heakal (2008), balance of payment is simply an approach where countries watch over their international transactions that are monetary in nature. Balance of payment is composed of current account, capital account, and financial account thus is designed to include all financial flows into and out of the country. In this context balances of payment curve point up a situation where outgoing payments and in-coming are at a balance. Such a situation of equilibrium is meaningful under conditions of fixed exchange rates. Equilibrium is attained when debits and credits are equal. This is attainable when a government utilizes fiscal policy, either expansionary or contraction fiscal measure. Expansionary fiscal policy takes place when taxation is reduced; public spending and interest rates are lowered. These actions, which are variable within the aggregate demand model, facilitate ease of obtaining credits. The aim therefore of fiscal policy in relation to balance of payment is to stimulate total spending in an economy. The other method of correcting imbalances in an economy is improving productivity and hence competitiveness which goes along in increasing desirability of exports (Paul, 2009). Conclusion This paper gave an elaborate description covering aggregate demand and how it is relates with economic growth, unemployment, inflation, and balance of payment. Aggregate demand is simply the total amount goods and services demanded in an economy within a specific period of time and a certain price level. Growth, unemployment, inflation and balance of payment are analyzed in depth against aggregate demand. Read More