Aggregate Demand and Supply

Effects of Changes in AD

The effect of changes in AD will cause different effects depending on the phase of the business cycle.

Trough or Severe Downturn

During a trough or a downturn, an increase in AD will have a positive impact on the economy. This is shown in the below diagram.

In the above digram, we can clearly see an increase in aggregate demand has cause a small increase in price level as competition for resources increase but a greater increase in real GDP. This is because the economy still has a large spare capacity, meaning competition for resources is still low. 

The effect of an increase in Aggregate Demand during a trough is likely to have the following effects:

  • Increase price levels towards target band of 2-3% (Positive)

  • Increase economic growth 

  • Decrease unemployment as increases in economic growth will increase employment of resources

  • Lower deficit budgets due to automatic stabilisers with more taxation receipts from increased economic activity (eg more GST, income tax and company tax) and less welfare expenditure due to lower unemployment

  • Beginning of a contractionary stance by the RBA as the medium term inflation outlook increases

Boom or Near-End Upswing

In the above digram, the economy is nearing full employment. As a result, increases in aggregate demand will mainly increase price levels with a minimal effect on increases in economic growth as it will increases competition for already employed resources. In the above diagram, an increase in aggregate demand from AD1 to AD2 will cause a large increase in price levels from P1 to P2 and a small increase in Real GDP from Y1 to Y2.

The effect of an increase in Aggregate Demand during a boom is likely to have the following effects:

  • Increase price levels above target band of 2-3% 

  • Little or no increase economic growth 

  • Little or no change in unemployment - cyclical unemplyoment is around 0%

  • Positioning towards a Government budget surplus as high levels of economic activity increase taxation receipts (eg increases in income tax, company tax and GST) and lower welfare payments due to low unemplyoment

  • Contractionary stance set by the RBA as the medium term inflation outlook is still above the target band - the bank will continue to increase the cash rate to lower economic activity

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