This distinction helps explain why economies sometimes struggle with unemployment, while at other times they face inflationary pressure. The relevance of this framework is particularly clear in the Indian context, where the economy has shifted between these two regimes at different points in time.
An economy is said to be demand-determined when output and employment are constrained by insufficient aggregate demand rather than productive capacity. This situation arises when there is idle capacity and unemployment. Firms are willing and able to produce more, but do not do so because demand is weak.
In a demand-determined economy, increases in demand lead to higher output and employment with little inflationary pressure. The central macroeconomic problem in this regime is unemployment.
Indian context: During periods such as the post-2012 investment slowdown and the COVID-19 shock, India largely operated in a demand-constrained environment. Despite available labour and capacity, weak consumption and private investment limited output growth. In such situations, expansionary fiscal policy and demand support are effective in raising employment and output.
An economy is supply-determined when output is constrained by productive capacity. Aggregate demand is strong, but firms cannot increase output further without increasing costs. As demand pushes against capacity constraints, prices rise instead of output.
In this regime, the main macroeconomic problem is inflation rather than unemployment. Policies that further stimulate demand tend to worsen inflation without significantly increasing real output.
Indian context: In recent years, certain sectors in India have faced supply-side bottlenecks due to infrastructure limitations, global commodity price shocks, logistics disruptions, and skill shortages. Strong demand combined with these constraints has contributed to inflationary pressures. In such situations, supply-side reforms and capacity expansion are more effective than demand stimulus.
The same macroeconomic policy can have very different effects depending on whether the economy is demand- or supply-constrained. Expansionary policies raise output and employment in a demand-determined economy, but mainly raise prices in a supply-determined economy.
India does not permanently belong to one regime. It moves between demand-determined andsupply-determined phases depending on the business cycle, sectoral conditions, and global shocks.
Demand-determined economies are characterised by unemployment, while supply-determined economies are characterised by inflationary pressure. For India, effective macroeconomic policy requires correctly diagnosing which constraint is binding at a given time, rather than relying on a single framework in all situations.