The demand constrained economy is an economy where aggregate demand is not enough to drive up the level of output in the economy. It is common in capitalist economies. The opposite is the supply-constrained economy, which is common in socialist countries.
The capitalist economy rarely produces at full capacity. Therefore, unemployment is a common phenomenon. Unemployment can increase or decrease, but never be zero.
When demand increases, producers raise production, pushing the total output of the economy to grow. Expanded production creates more labor and causes unemployment to fall.
Characteristics of demand constrained economy and policies
Limited demand makes the economy less fully use its productive capacity. As a result, some factors of production are unutilized, creating unemployment and unsold stock of raw materials.
Because the source of the problem is on the demand side, policies aimed at eliminating supply constraints do not lead to higher economic growth. Conversely, demand-side policies are preferred.
To encourage demand, the government can implement expansionary policies, both fiscal and monetary. Various policy options to promote economic growth include:
- Increasing government spending
- Lowering tax rates
- Interest rate cut
- Lowering the reserve requirement ratio
- Open market operations by buying government securities