Answer to Question #242354 in Macroeconomics for Danu

Question

Policymakers who can influence AD cannot offset the adverse effects of a recession due to a fall in AS’. Do you agree with this statement? Explain the answer in words and using an AD-AS diagram.

Answer 1

Policymakers can influence aggregate demand through various measures such as fiscal and monetary policy. Policymakers can increase the government expenditure, taxation policy, increase exports, provide consumption and investment incentives or curb them through various means. These affect the demand side of the national income. This is easier for policymakers, as policymakers will only work in one direction. This means policymakers will either increase government spending or reduce taxes for purpose. But, there is no trade-off or situation were fulfilling one objective will harm the other. 

In contrast, on the supply side, the adverse effects of reduction in aggregate supply are high unemployment, higher inequality, higher borrowing by government, falling average wages and incomes. If policymakers want to control them, then, for example, reduction in unemployment will increase inflation, or increasing wages will also increase the borrowings, and so on. This means the policymakers find various tradeoffs in offsetting one effect over the other. There are various external shocks as well which affect the AS and cannot be effectively addressed by policymakers. Reducing inflation will need to reduce aggregate demand and money supply, but this will make the recession deeper.  Hence, yes this statement can be agreed upon.

AD/AS diagram:

For example, reducing inflation through reducing aggregate demand by policymakers also reduces overall aggregate supply and production along with inflation, which invites more recession.