Consumption is the largest
part of AD. All the consumption decisions within the economy, including all non-investment
purchases by households, individuals, and firms, add up to around two thirds of
AD. In addition, the Keynesian economic theory asserts that there is a link
between consumption and investment, which can drive AD upwards, as firms invest
more when they see that consumers are purchasing more goods and services. Investment
is a sustained addition to long-run aggregate supply, or capital for short.
AD can be plotted against
LRAS on a two-dimensional graph. If AD and LRAS meet at the point where there
is maximum real GDP/GNI with no tendency for the price level to rise, the
economy is at macroeconomic equilibrium.
On the other hand, if AD
is ‘racing ahead’ of the capacity of the economy to grow real GDP, then the
price level will rise as a result of demand-pull inflation. Therefore, more
consumer spending could lead to higher prices, all other things remaining the
same.
Inflation is not simply
caused by demand-pull pressures, however. It is also the case that governments
have to consider external as well as domestic factors. Equally, monetarists
believe that all inflation everywhere is a monetary phenomenon and that other
factors are secondary.
Exchange rates can have a
complicated relationship with inflation. For example, net exports are a
component of AD. If exports rise, foreigners will require more of the currency
to buy them, which will tend to push the currency up. This could lead to more
employment by exporters, and thereby to higher spending by employees, as well
as more borrowing. These things would create inflationary pressures. In
addition, money flowing into the economy from international investors, would
boost the currency, provided that it is floating.
All of these things would tend
to lead to a monetary response, in the form of higher interest rates as the
central bank tries to control inflation. This could be balanced by lower or no
government deficits and higher national debt repayment, leading to lower taxes
in the future, however.
An inflationary bubble
risks consumers and firms ‘buying in’ lots of imports, especially if the
currency is initially pushed up. This will eventually bring AD down as imports
are a leakage from the flow of income. It will also have a downward effect on a
floating currency. If a J-curve applies, then the trade balance will stabilise after
a period of adjustment, provided that demand for imports and exports is elastic.
If the currency is fixed,
or if government is particularly concerned about international investment on
the capital and financial accounts of the balance of payments, inflationary
pressures would not self-correct. Higher domestic inflation would mean, with a fixed
currency, higher costs and lower productivity, a decline in the terms of trade,
and greater difficulty in paying for imports with exports. Governments would
have to use fiscal and monetary policy, and possibly trade and exchange controls,
to avoid a balance of payments crisis. They would have to slow demand down by blunt
force measures like higher taxes and cuts in government spending.
In an open economy, when
not faced by emergencies, governments have preferred to grant central banks the
power to manage the economy through the central interest rate, or in recent
years, quantitative easing. This allowed governments to concentrate on suppressing
inflation by only spending to invest, encouraging work, shifting to expenditure
taxes, and encouraging savings and investment.
Unfortunately, since the
covid crisis, added to the Ukraine crisis and growing debt problems,
governments have felt it necessary in open economies to raise spending, keep
taxes low, run deficits, and accumulate debt. This is now adding inflationary
pressure inside and outside economies at the same time as cost-push inflation,
and could lead to stagflation.
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