Question

Assume 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

As demand is rising aggregate demand curve shift rightward from AD to AD as shown in diagram this cause a rise in price level from P to P' and rise in real GDP from Y to Y' as output rises firm will hire more workers and this cause fall in unemployment this will increase demand for workers if demand for workers rises wages also rises leading to wage push inflation. Higher wages increase disposable income of employees which cause increase in consumer spending.