To reduce their output, firms will reduce their demand for labour from ADL to ADL1. “Mr. Pierce was laid off from his job a technical recruiting firm in November”.
If people are unemployed, there will be even less consumption. Low aggregate demand will result into low inflation of even deflation. This is supported by Philips curve:
Inflation Rate (%)
A
B
0 Unemployment Rate (%)
Since wage form a high percentage of total costs, it is strongly reflected in final prices, creating a relationship between unemployment and inflation. As unemployment rate rises, inflation decreases.
The US economy is currently moving towards the trough phrase. “There have been a number of signs in recent weeks suggesting the recession may have bottomed. Sales and construction activity picked up in March; consumer surveys show households are gaining confidence; and business surveys indicate companies’ outlooks, too, are brighter.” We can predict that in the coming weeks aggregate demand will pick up, the economy will enter the recovery phrase and the cycle will repeat itself.
Although households are gaining confidence unemployment is still a concern for the people and government.
Real GDP
Time
In this situation the government should increase its spending to fill up the deflationary gap and too boost demand.
The government could adopt the following policies:
The Keynesian Multiplier should be taken into effect; an increase in government spending would result in a proportionately larger increase the national income. This increase in Government Spending would increase the incomes of those firms where the money has been spent, this would in turn boost the spending of those firms who receive this extra income, and they would go ahead and spend it too. This would increase the aggregate demand thus causing employment in the economy. “Usually, when people think economy is improving, they will boost their spending”. However there is no guarantee that people will spend their extra disposable income; if consumer confidence is low people might prefer to save and the demand will remain depressed. “The recent rise in stock market showed the economy on mend, he was still cutting back sharply on cost”. “Americans are desperate to rebuild their savings.”
This in turn, enabled the Federal Reserve should utilize their monetary policy of interest rates, an decrease in it would act as a corrective measure for the fall in aggregate demand, since, due to low interest rates, consumers would be tempted to spend; which would increase consumer spending. Consumer Spending being a component of Aggregate demand would result in increasing aggregate demand since AD = C + G + I + (X – M). Thus with the increase in investments and consumer spending, the aggregate demand would also increase and unemployment would decrease. If consumer confidence is low, then there is unlikely to be an increase in borrowing to finance consumption and investment. There is likely to be a lag before the policy comes into effect. If the economy has already recovered, the extra impetus can be inflationary.
Glanville, Page number: 265
