Aggregate Supply and Aggregate Demand Analysis

In the monetarist perspective this link looks as follows (see Figure 1). Suppose, money supply is continually increasing, whereas, at the outset, economy is in equilibrium (point A) at full employment and with output at the natural level. If monetary policy is accommodative to budget deficit, money supply continues to rise for a long time, the aggregate demand schedule will shift to the right (AD1 => AD2), thereby causing output to increase above natural level (point A’). However, growing labor demand then pushes wages up, which in turn leads to the shift in aggregate supply leftwards until it reaches AS2 position (AS1 => AS2). In point B the economy has returned to the natural level of output, however, at the higher price level (P2 instead of P1).

Figure 1. Aggregate supply and aggregate demand analysis

If the money supply keeps on growing the next period, aggregate demand will again shift to the right (AD2 => AD3). Then after a while, the AS schedule will move to the left up to the AS3 position. At the same time, the economy has passed the way from point B to point B’, and then to point C. Output has temporarily increased above the natural level, but eventually has declined, while the price level has climbed up to the new height (from P2 to P3)[2].

Keynesian analysis of the situation predicts the same movements in aggregate demand and aggregate supply curves. The only difference lies in the timing: monetarists stress that the reaction of AS would be quick so that output would not remain above its natural level for a long time, while Keynesians believe this adjustment to be much slower.

Fiscal policy or supply-side shocks per se cannot produce consecutive increases in price level. If changes in government expenditures are one-shot and not ever-increasing, then such a policy can generate only a temporary increase in the inflation rate. Moreover, negative aggregate supply shocks cannot produce continually increasing price levels, provided that money supply, and thus aggregate demand, remain unchanged. Basically, these negative supply shocks will bring the economy below the natural level of output and employment and at a higher price level only temporarily. Soon, however, with labor market adjustment the process will go backwards, so that the economy will end up sliding along aggregate demand curve to the initial price level and natural level of output and employment.

Thus, we seem to have established that high inflation can only take place along with a high growth of money supply.

Date: 2015-02-28; view: 726