Explain the effects of an increase in aggregate demand.
Aggregate demand is a term used by economists to denote the total spending on goods and services produced in an economy. Aggregate demand consists of four elements: consumer spending, investment expenditure, government spending and the net expenditure on imports and exports. From a Keynesian economist’s perspective, they would state that an increase in aggregate demand when the economy is at full employment will be purely inflationary. However this all depends on how close an economy is to full employment of resources.
If the economy is in a deep depression and has a lot of resources not being used at full employment, then an increase in AD would see an increase in output from AD to AD1. This, therefore, will increase output from Y to Y1, but keep price at the same level due to an original low level of resources at full employment. Unemployment levels will also fall, meaning more people have jobs and therefore disposable income will increase. More disposable income would then see an increase on consumer spending( a component of aggregate demand), which then in turn would increase aggregate demand even further creating a multiplier effect. Another possibility is that an economy could already be close to full output(AD2) and an increase in aggregate demand from AD2 to AD3 would see a rise in inflation. Output will still increase from Y2 to Y3 however equilibrium price levels will rise from P to P2. This is because if an economy picks up, some firms will have reached or be close to reaching capacity output, and shortages of certain factors of production, such as skilled labour, will being to develop. This will cause an increase in price level and so inflationary pressure will start to build. If aggregate demand continues to rise as most firms reach their maximum potential output the effect of an increase of aggregate demand will consist mainly on prices. However this can be prevented...
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