The neoclassical perspective is different and takes the view that any increases in government spending and Aggregate demand in the economy will only lead to price rises in the long term. In the diagram below we can see the effect of an increase in AD from AD to AD1. This results in a short term increase in output to Y1. Y1 is beyond full employment equilibrium and can only be sustained if stocks are run down and labour is willing to work overtime. In the longer term as stocks are depleted and wages rise (thereby increasing business costs) supply will be cut back to a full employment level. As we can see the long term effect there is an increase in prices and no change in real output.
Neo-classical diagram 2
Japans reliance on Keyntian policies to fend off the economic downturn would indicate a shift of economic priorities away from inflation and towards unemployment. This trade off was theorised by Phillips. The diagram below shows the Phillips curve which illustrates the negative relationship between inflation and unemployment. As we can see low levels of unemployment are usually associated with high levels of inflation. However Phillips perspective is short run view of this relationship. In the longer term it has been suggested that in fact there is no trade off.
As we can see from diagram 4 increases in AD lead to short term increases in output(Y(f) to Y1) with equivalent increases in employment along the short run Philips curve. However as we know the increase in output beyond full employment eventually leads to rise in business costs and therefore SRAS will shift to the left to SRAS1 and full employment level of output. On the Philips curve this is equivalent to the move from B to C and a shift of SRPC to SRPC1 as we can see we are now back on the long run philips curve and at full employment equilibrium. The only result in the long term is an increase in prices.
An alternative solution to japans demand management strategy would be to adopt an supply side policy. Supply side policies focus on increasing the potential real output. The supply side refers to attempts to increase the factors of production. Governments can adopt an interventionist approach or encourage the market to do this. Examples of this would be deregulation of labour markets (for e.g. take away the minimum wage), relaxing immigration laws, tax breaks for capital investment and better access to university education. The effect of this can be seen in the diagram below.
As a result of the supply side policy LRAS shifts from LRAS to LRAS1. as a result potential real output increases and prices fall from P to P1. The problem with this is that these policies take a long time to come to effect and as Keynes said “were all dead in the long run”.
With a shrinking economy and continued inflationary pressures Japan’s response is complicated by the potential problem of stagflation. This is illustrated below. Here we can see that SRAS shifts from SRAS to SRAS1 causing an increase in prices and a fall in output. This is most likely to have been caused by the higher cost of energy in Japan. If Japan continues with demand management we can see this would cause further inflationary pressure as AD increases to AD1. it is even more essential therefore that demand management is accompanied by supply side policies.
