Monday, 17 November 2008

Is world aggregate demand sufficient for growth?

Is world aggregate demand sufficient to keep the world economy growing? As the world's industrial economies enter a downturn, and people there have less money to spend, the demand for goods from developing countries may not be enough to purchase all the goods produced in the world, and they may reduce production, leading to lower incomes in their countries and further reductions in demand and a worsening downturn.

The downward demand spiral can be analysed by looking at marginal propensities to consume. When developed country consumers were spending large proportions of their incomes, then many goods produced around the world could be sold relatively easily. As the consumers reduce their expenditures these goods are more difficult to sell, because purchasing power is owned by people with lower propensities to consume out of their income, like the very rich in developed countries, or people in high investment developed countries. If they scale back their production in response, then developed country consumers could have lower incomes from their own jobs, and so the situation has repeated with the same low aggregate demand propensities, except the economy has been shrunk by a certain percentage. The economy could keep on going like this, until there is no economy at all.

Of course, this shrinkage hasn't happened before because of government intervention to increase marginal propensities to consume (which is what borrowing to spend does), and also because as people get poorer they tend to spend more of their incomes on essentials like food. This final catch-net for the economy does not redistribute wealth back to the developing country consumers, at least initially, but rather increases the consumption propensity among low consumers.

Disaggregating aggregate demand helps to show whether the downward spiral could occur. Developing country exports to developed countries include articles like soft toys and other goods which would be considered luxuries in much of the world, so the risk of a gap between world demand and world supply of goods is increased.

Ignoring the exact composition of aggregate demand, the question can be restated more broadly and quantitatively as what global marginal propensity to consume will support optimal growth? The requirement is that investment is as high as possible consistent with maintaining its productivity and all goods produced being sold. The first part of the requirement is that the supply side of the economy makes as much as possible, and the second part is that the demand side wants it. I think that there are implicit assumptions about market operation and investment incentives built in to the requirement, but I haven't stated them.

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