Question

Why is it not possible for all countries to follow a demand-focused (i.e. expansionary) growth strategy, given that the world can be viewed as a closed economy? - 15 marks

Answer 1

Case Specifics

When we view the entire world economy as closed, what that essentially means is that the supply side has a constraint that beyond a certain point, the supply cannot be extended any further up until there is significant improvement in per unit cost via technological advancements or any other technique through which the world begins producing more goods or services.

An expansionary demand strategy is a short-term method of making a country and its economy grow. However, the core risk involved with it is that the economy may see uncorrected inflation in the long run as a result. Consider the fact that the demand exceeds the supply. In this situation the prices of goods and services begin to rise and go beyond a point wherein suppliers are unable to increase their produce post a certain limit. Any demand post this, results in rise in prices as people go on demanding but there is no availability of supplies and the end result is that it causes hyperinflation in the economy, wherein the prices go on increasing until demand is curtailed by measures such as increased taxation or increasing the interest rates.

Thus, we can conclude by saying that it is not possible that all countries follow a demand based expansionary growth, because raw materials in a closed world are limited which restrict how much the producers can produce in the world. As this happens, inflation would rise as demand goes on increasing and supply is unable to catch up with the same.

Graphically this happens as follows: -

In the graph, we see that the Aggregate Demand Curve is Downward Sloping and while the Y axis depicts price, the X axis depicts quantity. Here, the Quantity goes on increasing in terms of the demand which shifts from AD1 to AD2 and then to AD3 & AD4. The Supply however changes from Q1 to Q3 and then does not see a rise. Due to this, the price goes on increasing with increase in demand as is evident from the shift between AD3 to AD4.

Thus, even though prices have shifted from P1 to P4 the only shift in supply has been from Q1 to Q3. This is because of the supply threshold explained in the sections above.

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