Effects of an expansionary macroeconomic policy
For the purpose of this assignment, the following hypothetical scenario exists: A new government has been elected under the assumption that its expansionary macroeconomic policy will lower the rate of unemployment from the current natural rate of 7% to the reduced rate of 5%. This being the case, what will be the economic effects, both in the short- and long-run, according to the AS-AD model? In order to understand the AS-AD model, we must first understand the inherent relationship between aggregate supply and aggregate demand. In its simplest terms, this relationship works on the principle that price is determined by the ratio of supply to demand: a high demand and low supply necessitates a high price, whereas a low demand and high supply would be indicative of a lower price. However, many more factors influence this AS-AD relationship. For instance, aggregate demand is influenced by interest rates, business and consumer confidence in the economy, the anticipation of inflation, and real wealth. Aggregate supply, on the other hand, is influenced by not only supply of resources, but also productivity by the workforce and production costs. Speaking in general terms, an increase in aggregate demand might have the following short run consequences: prices will rise, output will increase in order to attempt to meet the demand, and ultimately production will exceed the current workforce’s capacity, thus creating a demand for a larger workforce. In the long run, a new equilibrium will be established with higher prices for product, production costs, and labor.