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Domestic Demand, External Pressures, and Inflation

 

 Domestic Demand refers to the accumulated (that is, aggregate) demand within all the markets of an economy. As such, it can be handily summed up in a formula, C+I+G+X-M, where C is consumption, I is investment, G is net government spending, and X-M is net exports. This is usually referred to as ‘AD.’

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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