INSIGHTS: Limits on the Level of Demand a Country Can Afford
Volume 13, Number 4, Fourth Quarter 2015
With home goods (e.g urban services) output equals demand; when demand increases we put older machines back to work. But the real wage depends on the productivity of the marginal home goods plant. Because money prices go up when the real wage goes down, an increase in demand is inflationary.
On the other hand, with tradable goods (e.g., commodities), an increase in demand results in virtually no increase in local output, hence in an almost equal increase in the trade deficit.
In both cases, a failure to invest in plant capacity results in an increase in demand the country can’t afford.