Question

Discuss the results of aggregate demand increasing more than potential GDP and the results where aggregate demand curve increase less than potential GDP

Answer 1

Introduction: -

To understand what would happen if aggregate demand increased or decreased beyond potential GDP let us analyse the two terms first.

Aggregate demand, simply refers to the total demand of goods and services in the market. It is the sum total of four key components. Consumer Spending, Government Spending, Private Investment and Exports.

Further, when we look at GDP it refers to the total supply of goods and services in the economy in a given time frame. Usually, the GDP is calculated once in a year when it is reported.

Potential GDP on the other hand looks at the aspect of how much an economy can produce in a given year. It sets the upper limit of production for any country.

Case Specifics: -

Now, we further look at the aspect wherein aggregate demand could be more than the potential GDP. This would mean that consumers are demanding more products as compared to what the industry is capable of catering to. If that happens it would lead to inflation in the economy. This is because suppliers can sell at a higher price point only till, they can supply the product itself. If there still is higher demand for the product, it would be possible that some of the people would never be able to get this demand fulfilled. Such situations are dangerous for any economy and are usually dealt with reducing the supply of money in the country.

Two key institutions that regulate the supply of money are the government and the Federal Reserve. Government in this case can directly alter their spending and decrease the same and increase taxes which would lead to people having lesser money in their hands and thus demanding lesser in the economy respectively.

On the other hand, if the aggregate demand was to go lesser than the potential GDP, it would mean that there is a recessionary gap in the economy. This is a situation in which people demand lesser of goods and services because of lesser availability of capital. Accordingly, the investment of private players also is lacking and export and government investments are lower in comparison to what an economy can achieve.

We treat this situation the exact opposite of inflation as explained above, we increase the money in circulation and this helps in increasing the demand in the country respectively.

Please feel free to ask your doubts in the comments section.