Saturday, July 24, 2010

Managing Aggregate Economic Demand

Aggregate demand management in macroeconomics means adjusting the level of demand to try to ensure that the economy arrives at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary gap), then the government will need to reflate the economy. If there is an excess of demand, such as in a boom, then the government will need to deflate the economy.

The problem with the US economy today is weak aggregate demand. When aggregate demand is weak or declining, economists generally advise that both monetary and fiscal policy-makers consider reflationary policies. Reflationary policies to boost the level of economic activity might include:
  • Increasing the level of government expenditure
  • Cutting taxation (either direct or indirect) to encourage spending
  • Cutting interest rates to discourage saving and encourage spending
  • Allowing some money supply growth
The first two policies would be considered expansionary fiscal policies, while the second two are expansionary monetary policies. The objective of all the above policies should be to increase aggregate demand and therefore the level of output. The diagram below depicts how aggregate demand results in declining prices and production output:

I maintain that the US should be engaged in monetary expansion and fiscal spending at this crucial time for the economy. The austerity hawks are arrogantly wrong in asserting that less spending will somehow restore aggregate demand and ultimately prosperity for America.

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