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.

There are several ways in which this new hypothetical government can decrease unemployment through either monetary policy or fiscal policy.  As far as possible monetary policy actions are concerned, either the government can decrease the interest rate in order to stimulate investment and spending; or, the government can increase the volume of money in circulation.  The government would also have the following fiscal policy modifications at its disposal: increasing government spending, or reducing taxes in order to decrease the cost of supply.  A reduction of the interest rate would increase customer spending, thus increasing demand, output, and price.  The final result is that this increased demand requires a larger workforce to cover the demand for increased production.  In other words, the government’s plan for monetary expansion necessitates a lower interest rate, which stimulates investment, output, and production, thus lowering the unemployment rate.

However, at some point the government would need to increase interest rates in order to restore economic equilibrium.  Additionally, if output is above its natural level, prices will initially increase, but in the long run output will eventually stabilize and prices will settle back down.  Thus, a reverse chain reaction will occur where all aspects of aggregate demand will return to previous levels.  Therefore, the government’s increase of interest rates in order to reduce unemployment rates will have positive short-term effects in stimulating the economy, but will have virtually no long-term effect without supplementary intervention or a change in productivity.

One way to ensure long-term results in this expansionary macroeconomic policy is to effect radical change within the workforce.  Long run growth in aggregate supply requires a sustainable increase of real output.  Thus, should a technological innovation increase productivity allowing a reduction of production costs, prices can be reduced as well.  Output levels will then stabilize at a higher natural level, and stabilized prices and wages will follow.

In conclusion, while an expansionary macroeconomic policy instituted by a government to reduce the unemployment rate would most-likely have the desired positive short-run effect (barring unanticipated variables such as loss of confidence in the economy); the long-run effects would be fairly neutral.  The system would inevitably return to its former equilibrium without long-term, sustainable increases in productivity and/or output.

References

Jackson, J. and McIver, R.  Macroeconomics.  6th ed.  Sydney: McGraw-Hill, 2001.

MacIntosh, M., et al, eds.  Economics and Changing Economics.  UK: International Thompson Business Press, 1996.

McTaggert, D., Findlay, C., and Parkin, M.  Macroeconomics.  4th ed.  Sydney: Addison-Wesley, 2003.

Stegman, T. and Junor, B.  Introductory Macroeconomics.  Sydney: Harcourt Brace Jovanovich, 1993.

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