Foundations of Supply Side Economics

Question: Discuss about the Foundations of Supply Side Economics. Answer: Introduction: The central theme of any economy is to create a condition where there is subtle balance between the demand poised by the consumers and the supply generated by the producers. This subtle balance should be maintained at the lowest possible cost and at the highest level of employment in the economy (Hubbard O'Brien, 2015). The point where none of the economic agents gets any incentive to deviate from their existing condition unless some external forces are applied is known as equilibrium. Equilibrium can be either stable or unstable in nature. This answer tries to highlight the stability in the equilibrium level of the economy with the help of the basic concepts of aggregate demand and aggregate supply theory. Both the long run and the short run aggregate supply curve has been used to analyze the reason as to why the economy does not find any incentive to digress from the equilibrium in the long run. Discussion of the theories and its interpretation: Concept of equilibrium: The term equilibrium implies equal balance. Generally, the term was used in physics but later on was adopted into economics. In economics, equilibrium means the process through which balance between the economys demand and supply (Bernanke, Antonovics, Frank, 2015). It is established through competition in the market either under the free hand or under restriction. Equilibrium can be classified into various types depending upon its nature of occurrence. This write up focuses on the stability of the equilibrium, which implies that whenever there is a match between the supply price and the demand price of any goods (Buiter, 2014). The economy is classified into three types of market. They are: Product market, labor market and financial market. The global equilibrium is attained by maintaining equilibrium in each of these interrelated markets. The IS-LM model gives us the concept of AD curve which was then interrelated with the AS curve to explain the stability of long-term equilibrium . Theory of aggregate demand: The total quantity of services and goods demanded by the consumers within the economy is known as aggregate demand. The aggregate demand curve shows the quantity that has been demanded at each possible price level. The balance between the planned expenditure and the actual expenditure of an economy is highlighted by this curve (Gal, 2013). Theory of aggregate Supply: Aggregate supply has been defined as the total production of all the services and goods that has been produced in the market. It is generally upward sloping in nature because the producers gets incentive to produce more goods and services at higher prices but they are unwilling to produce less quantity of goods at lesser price (Canto, Joines, Laffer, 2014). Equilibrium in short run: In the short run, at-least one input of production remains fixed. Usually it is assumed that the capital is the fixed factor of production. The resultant effect is shown as follows: From the above figure, it can be said that the equilibrium prices and quantity at initial level is P and Y respectively. There may be some sudden increase in demand within the economy it is going to shift the AD curve outward (Michaillat, 2013). On an immediate level as there is no change in the supply level, hence the equilibrium is revised at P1 and Y1. Though it can be seen that Y1 is greater than Y and for an economy more output is preferred to less but it also raises the price level. Hence, government finds it necessary to intervene and maintain the balance of the economy. Equilibrium in long run: In the long run equilibrium is ensured at the intersecting point of three different curves, namely, the AD, SRAS and the LRAS curves. The figure below shows the long run equilibrium: In the long run, the economy is said to be near full-employment level that is at NAIRU. The economy uses all its resources and work force to produce the maximum possible output and hence the long run aggregate supply curve is vertical in shape (Keating, 2013). Any increase in demand in the long run can initially shift the demand curve outward as shown by AD1. Ideally then the equilibrium should be at the intersection of the AD1 and SRAS curve with higher level of output at higher price. Nevertheless, at the same time the restricted supply in the long run ensures that output remains at Y1 and hence increase in demand leads to increase in the price level only. As a result, the demand for the goods again gets reduced and equilibrium is restored to the initial level where the three curves meet. In the long run as the equilibrium gets re-stored even after it has been distorted as a result of changes in the economic factors hence it is known as stable equilibrium. The government has fiscal policy at their hand to maintain the balance within the economy. They take up either expansionary policy or contractionary policy according to the level of distortions (Schwieelmann, 2013). Through these policies, the government tries to keep the inflation under control and the unemployment level within or near its natural rate so that the asset bubbles are not created in the economy and the economy does not face any severe crisis. Conclusion: The write up can be encapsulated by connoting the fact that all three types of market are highly inter-related and hence any distortion in one of the market leads to the global economic distortions. Hence, the government of all the nation tries to implement the policies in a way so as to maintain subtle balance in all the markets. In the short run, though the market sees fluctuations but in the long run the equilibrium is ultimately established. Since, in long run all the resources are variable in nature and are used optimally, so there is no scope of increasing the output and hence the equilibrium is obtained at the juncture of the AD, SRAS and LRAS curves. References: Bernanke, B., Antonovics, K., Frank, R. (2015). Principles of macroeconomics. McGraw-Hill Higher Education. Buiter, W. H. (2014). Temporary Equilibrium and Long-Run Equilibrium. Routledge. Canto, V. A., J., D. H., L., B., A. (2014). Foundations of supply-side economics: Theory and evidence. Academic Press. Gal, J. (2013). Notes for a new guide to Keynes (I): wages, aggregate demand, and employment. Journal of the European Economic Association, 11(5) , 973-1003. Hubbard, R. G., O'Brien, A. P. (2015). Macroeconomics. Pearson. Keating, J. (2013). Interpreting permanent shocks to output when aggregate demand may not be neutral in the long run. Journal of Money, Credit and Banking, 45(4) , 747-756. Michaillat, P. . (2013). Aggregate Demand, Idle Time, and Unemployment No. w18826. National Bureau of Economic Research. Schwieelmann, J. (2013). Effects of Fiscal Policy. Grin Verlag Ohg.