The aggregate demand curve shows the inverse relationship between the average price level and the total demand. The movement along the demand curve is caused by the change in prices. The lower the price, the higher is the demand and vise versa. This is shown through P1-Q1 and P2-Q2 on the aggregate demand curve. Any changes in any of the aggregate demand determinants will cause the aggregate demand curve to shift. An increase in aggregate demand will cause the curve to shift to the right, from AD to AD2 and a decrease in aggregate demand will shift the curve to the left.
Aggregate Supply:
Aggregate Supply is the total amount of goods and services that an economy produces at average price level. There is some disagreement between Keynesians and Monetarists about what determines the level of aggregate supply. Keynesians argued that supply is determined by the level of aggregate demand. The higher the prices, the lower is the purchasing power, therefore the quantity of goods and services that can be acquired with a certain income falls. As soon as the aggregate demand decreases the aggregate supply must also decrease. The Monetarists followed Say's Law which argues that the government should stimulate production rather them consumption and that aggregate supply is determined by supply-side factors.
Factors such as: change in raw materials, change in wages and change in the direct tax on industry will shift the curve and are known as supply side shocks. When the costs of production go up the short-run supple curve will shift upward, from AS to AS1, and when the costs of production go down the curve will shift downwards, from As to AS2. From the short-run aggregate supply curve one can observe that the shift upward indicates the output stays the same while the price increases from P to P1.
b. Explain the difference between demand-side and supply-side policies.
Demand-side policy:
Demand-side policy is used to stabilize the economy by changing the aggregate demand. When there is a lack of demand the aim of the government should be to increase it. The most important demand-side policies are fiscal and monetary.
When using fiscal policy the government tries to influence the level of economic activity through controlling government expenditure and taxation. To stop recession and boost the economy, direct and indirect taxes are cut or there is an increase in government spending. This will shift the aggregate demand curve upwards from AD to AD2. In order to reduce the level of demand in the economy and to help reduce inflation, the taxes will rise or government spending will be reduced. Such actions will cause the aggregate demand curve to shift downwards from AD to AD1.
Monetary policy is used to control the level of the money supply and interest rates to influence the economic. When the economy is at recession the central bank will increase the economic activity through decreasing reserve requirements, buying government securities or lowering the interest rates, which will shift the aggregate demand curve upwards. To slow down the economy and fight inflation the central bank can increase reserve requirements, sell government securities or raise interest rates, which will shift the aggregate demand curve downwards.
The main advantage of the demand-side policy is that it works quickly, however it is very hard to predict and control.
Supply-side policy:
Supply-side policy is used to stabilize the economy by changing the aggregate supply. Supply-side economists argue that government should focus on stimulating the output of goods ad services, rather then trying to change the aggregate demand. The two main categories of the supply-side policy are: market orientated supply-side policy and interventional supply side policy.
The main idea of the market oriented supply-side policy, which is favored by the Monetarists, is to reduce the role of the government and to encourage individual enterprise. The most important market oriented supply-side policies are:
- Decrease in government spending
- Decrease in taxation
- Lower interest rates
- Reducing Monopolistic power
Many counties, such as France, Germany and Japan, favor the interventionist supply-side policy. Most are aimed to reduce the level of unemployment. This policy is favored by the Keynesians. The most important policies are:
- Nationalization
- Grants or tax credits for development
- Rationalization
- Information access
- Training
The goal of the supply-side policy is to shift the aggregate-supply curve to the right from Q1 to Q2. For the long run, the Monetarists and the Keynesians have different views considering the aggregate supply curve. Monetarists argue that the aggregate supply curve is independent of the aggregate demand and is therefore a straight vertical line.
Keynesians argue that if output increases, there will be no effect until it passes a certain point on the long-run aggregate supply curve. The moderate view is that there is a middle area where aggregate demand has some influence on the aggregate supply.
c. Which of the policies above do you consider to be the most useful? Explain your answer fully.
Both the supply-side and the demand-side policies are useful; however, they can be used to achieve different effects. The demand side policies work quickly because the increase in money supply is done directly through interest rates, taxation, etc. Within the next 6 month. It is used to deal with short term problems such as inflation or unemployment. Yet, it is very hard to predict an accurate outcome and the situation might go out of control.
Supply side policies take much longer time and reduce the pressure on prices and increase employment. They are safer and should cause a gradual improvement in the economy.
Demand side policies can be effective when there is little economic activity. But when the economy grows and there is more economic activity demand side policies become less effective because _____________________________________________ ________________________________________________________________________________________________________________________________________________so when the economy is doing well we need the supply side policy. However, demand-side policies often have supply-side effects and vise versa, therefore it is very important to take them in account.
Tax decrease may cause less work effort according to the Laffer Curve. At the same time even though supply side policies often increase efficiency they may also cause inequity to raise. Supply-side policies are basically designed to improve economic activity in the long run, while the demand-side policies are used in the short run.
