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.

Does GDP measure Economic Development?

• Examine the role of GDP figures as a measure of economic development. (15)
• GDP measures National Output, National Income and National Expenditure.
• GDP per capita gives a rough guide to average income per person in the country.
• GDP is a rough guide to living standards.

• Higher GDP enables more consumption of goods and services.
• Potential for Higher tax revenues, and therefore government spending on public services like health, education and transport.
• Higher GDP may create more employment opportunities.
• Generally countries with much higher GDP OECD countries have more economic development than low GDP

Limitations of GDP in measuring Economic Development

1. Depends on distribution of GDP.

For example, if 90% of GDP is owned by small oligarchy then the majority of economy may have low economic development. This is an issue for several sub saharan African economies, where high % of GDP is owned by small % of those in power.

2. GDP may underestimate economic development.

This is because official GDP statistics do not include black market; this is a significant part of subsistence economies. However, economic development often reduces the size of this "black market" or economic activity which is not recorded.

3. Difficult to Compare Living Standards through GDP.

This is because exchange rates do not reflect local purchasing power of a currency. For example, a Big Mac may cost $5 in Japan, but $1 in India. Therefore, comparisons need to take these into account.

4. Levels of Infrastructure important to economic development.

For example, GDP may not be used to improve infrastructure, communication and transport. These factors are very important for determining development. GDP does not indicate how money is spent. GDP may be used to finance projects that do not help education development.

5. Standards of education important for long term economic development.

6. Some countries may get high GDP from primary products, but struggle to develop and diversify into manufacturing and service sector based economy.

See also:

• Does Economic Growth Bring Increased Happiness?