AGGREGATE DEMAND. UNEMPLOYMENT AND INFLATION

Our model is of course a highly over- simplified representation of the real world. Let us now make it a little more complex, to show how to analyze more fully when rising demand will call forth additional output, when inflation, and when a mixture of both.

In the real world, it is not true that ris- ing aggregate demand will always call forth solely dollar for dollar increases in real g.n.p. up to full employment, and pure inflation thereafter. Actually, we would expect some prices to begin to rise before full employment is reached, because increases in demand might cause production bottlenecks and shortages in some sectors of the economy before full employment occurred in others. Demand would normally rise faster for some products than for others.

FIG. 5-2 As the dashed section of OB shows, when on
economy approaches full employment prices ordinarily
begin to rise before full capacity output is reached. Here
full-employment output OQ3 can be achieved only with
aggregate demand OD4, which would imply substantial
inflation.

To show this situation, Fig. 5-2 reproduces the aggregate supply curve from Fig. 5-1, as solid line OAB. But it adds a dashed segment which rounds off the corner where solid OAB has a sharp kink at A. If this dashed segment is correct, it shows that prices will begin to rise before we reach full employment. Put otherwise, it shows that we can reach full employment output OQ3 only with aggregate demand OD4 and the considerable in-flation that implies.

Try using Fig. 5-2 to predict the conse- sequences of different levels of demand. If de- mand rises from OD1 to OD2 the result is still purely rising output and employment as before; note that real g.n.p. of OQ~ implies massive un- employment with the economy operating at less than half its capacity. But suppose demand moves on up to OD8. Now, with the new dashed supply curve, some of the growth in aggregate demand will still induce more output but some will gO into higher prices. To push the economy all the way to its full-employment output of OQ3, we must now have aggregate demand of OD4, and with it a lot of inflation. Demand OD3 won’t do the job any more.

This situation can pose a difficult dilemma for economic policy-makers. As we approach OQ3, is it desirable to expand aggregate demand further in order to reduce unemployment to a bare mini- mum, even though this brings on some inflation? Or is it better to keep aggregate demand at a lower level, accepting some unemployment but also avoiding inflation? This is a problem which will be very much in the picture when we come to stabilization policy problems in Chapters 1O—14.

A second modification of our Fig. 5-1 model is in order if we want to use it in analyzing the impact of rising demand on unemployment and prices. In the real world, full-employment g.n.p. is never the precise amount implied by the vertical section of the aggregate supply curve in Figs. 5-1 and 5-2. As wages and prices rise, housewives, students, and older people enter the labor force. Workers put in longer hours. Industrial engineers find ways of increasing output per man-hour. Production managers push plants beyond their quoted capacities for months, even years. With enough pressure, there are many ways of getting a little more output. As demand rises, the full- employment ceiling on output is a mushy one, rather than a precise production possibilities frontier. To reflect this accurately, the vertical segment of OAB should bend over a little to the right. Eventually it must become vertical for any given time period, but the full-employment ceiling is less definite than it appears at first glance.

GROWTH IN PRODUCTIVE CAPACITY

The aggregate supply curves in Figs. 5-1 and 5-2 are for a given time period—say a year. They are what economists often call short-run supply curves. Over longer periods, of course, the produc- tive capacity of an economy can grow—for ex- ample, through investment in new factories, increases in the labor force, and technological progress. In that event, full-employment output each year is larger than the year before—the pro- duction possibilities frontier moves out. It is im- portant to note that if productive capacity grows this way, what is full-employment aggregate de- mand for one year will be inadequate to call forth full-employment output the next year.

FIG. 5-3 With more productive resources ond improved
technology, an economy’s productive capacity increases.
With increased capacity, more aggregate demand is re-
quired to call forth full-employment output. n years two
and three, here full-employment capacity has risen to
OQ4 and OQ5, respectively.

We can show this readily in Fig. 5-3. It reproduces supply curve OAB from Fig. 5-1, and adds on extended segments ACC and ADD to  show how potential real g.n.p. moves out year after year with new investment, more labor, and advancing technology. By the same token Fig. 5-3 shows that larger aggregate demand will be needed each year to call forth full capacity g.n.p.

Thus, the aggregate supply curve for year 2 is OCC. Potential real g.n.p. has moved out to OQ4, and demand OD4 is required to assure full- employment. In year 3 the aggregate supply curve becomes ODD. Potential real g.n.p. has now moved out to OQ5, and the necessary aggregate demand up to OD5.  

Chapters 6 to 14 are primarily concerned with the short-run behavior of the economy. They generally take the productive capacity of the economy as substantially fixed, although you can see that this short-run fixed supply curve model is not quite accurate. Then, in Chapters 15 through 18 we will turn specifically to the question of long-term economic growth, and the expansion of capacity will be the center of atten- tion. It is important both to utilize our existing capacity fully in the short run and to expand this productive capacity over the long run.