The Effect of Domestic Demand on an Economy

READER's QUESTION: Discuss the impact of an increase in domestic demand on the country's economy?

An increase in Aggregate Demand (domestic Demand) will have the effect of increasing economic growth and possibly inflation.



The higher output is likely to reduce unemployment. This is because as output increases, firms demand more workers to produce the extra goods.

If AD increases too much, the economy will get close to full capacity and therefore will cause inflation.

The increased domestic demand may also cause a deterioration on the current account balance of payments. This is because higher domestic demand would lead to an increase in imports.

The Effect of Increased Demand Depends on Many Factors.

1. What is the Long Run Trend Rate of Growth?

In China the economy can grow by 7-8% without causing inflation.
In the UK, the long run trend rate (average sustainable growth) is about 2.6%. Therefore, if domestic demand in the UK rose by 4-5% it would be likely to cause inflation and lead to a boom and bust economic cycle. This is because increasing AD by 5% is unsustainable. It would lead to a shortage of goods and therefore inflation would occur. This inflationary growth is unsustainable

2. How Much Spare Capacity is There?

If the economy is below full capacity, or if there is a recession, then an increase in AD will cause higher economic growth without causing inflation. However, if the economy is already close to full capacity then an increase in domestic demand will cause inflation.

3. Depends on Marginal Propensity to Import.

The MPM is the % of extra income that is spent on imports. If the MPM is high then the increase in domestic demand is likely to cause a big deficit on the current account balance of payments. The MPM is high if there is a shortage of goods produce in the country. The UK and US have a high MPM because they have had a reduction in their manufacturing sectors.