Explaining a BOOM using the AD-AS model The Business Cycle or Trade Cycle is characterised by a regular cyclical pattern with four distinctive phases: the expansion, the peak, the contraction, and the trough. The peak, also known as the boom phase of the cycle is characterised by the following conditions: A reduction in the rate of investment spending, resulting from high business costs, falling business confidence and a lower expectation of profit. Relatively high levels of employment with shortages of labour, and particularly skilled labour. Continued upward pressure on wages growth.
Relatively high levels of interest rates due to the demand for funds. Unfavourable trends in international transactions. Downward pressure on the domestic exchange rate. Shortages of materials and other resources due to relatively high production levels. Greater difficulty in increasing real production. Relatively high levels of industrial unrest and union / employer disputes.
Unlike the Keynesian model, the Aggregate Demand-Aggregate Supply model functions under the assumption that levels of production, income, employment, and prices may be determined not only by demand factors, but supply factors also. The AD-AS model is used in illustrating the effects of changes in aggregate demand and aggregate supply on levels of output (real GDP), income, employment and prices. Because this model provides us with an understanding of how the total economy operates, it can also be used in predicting future movements of economic activity. Aggregate Demand Aggregate Supply Model In relation to the boom phase of the business cycle, where real output, income, and employment are close to peak levels, the AD-AS model must show an expansion of these factors. This is shown on the AD-AS model as a shift in the macroeconomic equilibrium to the right (see diagram over page). If this is to occur however, one of the following must happen, demand must increase to that point, or supply must increase to that point, or a combination of both supply and demand must occur to push the macroeconomic equilibrium to the right.
If demand increases then so does the General Price Level, and there are inflation risks, if supply increases, then General Price Level goes down, and so does inflation. However, during an expansion of economic activity, demand automatically increases, as wage levels rise and the general public are able to consume more, hence a rise in GDP, and in inflation. Ultimately to push the macroeconomic equilibrium point down so as to reduce inflationary pressures, an increase in supply will, theoretically lower inflation levels, whilst maintaining economic growth levels. P Q, Y, GDP Q 1, Y 1, GDP 1 For example purposes, in relation to the business cycle, when the cycle goes from a trough to a boom, there is an increase in demand, and hence an increase in the determining factors as discussed previously. As shown in the graph above, this is possible through the expansion of the macroeconomic equilibrium point 1, to the macroeconomic equilibrium point 2. In order for this to happen, there needs to be an increase in demand, provided by consumers.
However this increase in demand raises inflation levels, which may become problematic (see figure below left). In order to maintain, or lower inflation rates an increase in supply is necessary (see figure below right). (P) (P) P 1 P P P 1 Real GDP, Y, E Real GDP, Y, E Basically, with respect to the boom phase of the trade cycle, the AD-AS model shows that, in the period of rising demand and inflationary pressures, alternatively in trying to decrease demand to avoid high inflation levels, there is the opportunity of increasing supply, which not only decreases inflation but also increases economic growth. This is a typical characteristic of the boom phase of the trade cycle, Policies enforced by the government in a boom phase are likely to be in increasing supply. The government employs policies and initiatives such as export promotion, payment of subsidies, lowering of company tax, and increased depreciation allowances in order to act as a stimulant of production to companies and thus increase total supply. Businesses respond to these initiatives by increasing total supply in the anticipation of increased sales and profits.
This results in satisfaction of economic objectives.