Boosting Aggregate Demand - The Way Forward for the Eurozone

Instead of adopting a conservative way of reducing debt by cutting back on spending, European governments should take on a more aggressive approach by doing exactly the opposite.

The Keynesian model shows that a country can be “stuck” in a recessionary (or deflationary) gap for a very long time due to downward nominal wage rigidity and insufficient aggregate demand. Keynesian economists therefore think a country must “grow” its way out of a recession, and considering the case of the Eurozone I cannot agree more. Countries in the Eurozone must boost its aggregate demand so that AD can shift to the right from AD to AD₂ and produce at the potential GDP (Figure 1). In other words, the Eurozone should make high economic growth one of their main priorities in the upcoming years.

Figure 1. Source: www.economicshelp.org

In order to achieve growth expansionary demand side policies must be in place. Firstly, the interest rates should be kept low.This way in encourages more borrowing from consumers and businesses, which therefore increases spending. Secondly, governments should increase spending in areas where there is an almost-guaranteed positive return. This is what we call fiscal stimulus packages. Such packages trigger a multiplier effect where the GDP return (or national income) exceeds the government spending that causes it and can in effect stimulate aggregate demand in an economy. An example of such investment is investment on infrastructure. This is actually what China did back in 2009, when it spent 1.5 trillion RMB on railways, roads and airport. By doing so, even in a time of global financial crisis, China maintained an impressive 9% real GDP growth rate.