Answer to Question #133998 in Economics of Enterprise for nonhlanhla

Question

Asssume the aggregate demand of an economy is rising at 3%, but its productive capacity is only rising at 2%. Discuss the type of inflation this would lead to. use a diagram to motivate your answer.

Answer 1

When demand rises by 3% and productive rise by 2% it means that aggregate demand rises by 1% more than aggregate supply.

 Consider below diagram, aggregate demand curve shifted more compared to aggregate supply curve. This results in price increase from P to P1 and output level rise from q to q1.Rise in price leads to inflation that is due to demand side inflation that is more than supply side inflation.