Answer to Question #146973 in Macroeconomics for Rose Dacket

Question

Explain, with the aid of a graph, the demand‐pull inflation. In your answer, consider the following:
 Graphical illustration of the demand‐pull inflation (5)
 Provide any three of your own examples/scenario that might cause the demand‐pull
inflation (6)
 Recommend the policy tools to use in order to curb each type of inflation mentioned
above (4)
You will receive more marks for your own original examples than for examples in your
textbook, from your lecturer, or on Learn.

Answer 1

a) Demand-pull inflation is inflation that emanates from business cycle swings. It occurs when actual real GDP exceeds potential real GDP. At this point, the growth in aggregate demand exceeds the growth in national output, fueling up prices. The graph below illustrates demand-pull inflation using AD-AS model.

The economy is initially in full employment equilibrium, Yf. The increase in aggregate demand from AD1 to AD2 created an inflationary gap as actual GDP, Ye, exceeds full employment income, Yf, exerting an upward pressure on the price level. The general price level increases from P1 to P2, indicating inflation if it become persistent.

b) demand-pull inflation is a long-run phenomenon that take place when the economy is at full employment equilibrium. It occurs when the following situations take place in the long-run:

• Government reduce income tax, resulting in an increase in disposable income hence aggregate demand

• emergence of war, leading to diversion of factors of production towards production of mitary goods. As a result, output growth falls in the consumer goods sector, leading to demand-pull inflation in that sector

• decrease in interest rates, leading to lower cost of borrowing, which increase both consumption and investment expenditure components of AD.

c) Deflationary, demand management, policies are required to contain demand-pull inflation.

• the government should increase income tax or reduce its expenditure on goods and services to reduce aggregate demand.

• In the event of war, the government should ensure that sufficient resources are availed towards production of consumer goods to prevent demand-driven price madness arising from shortages.

• the central bank need to increase bank rediscount rate to raise interest rates and discourage excessive investment and consumption at the time the economy has no excess capacity. Increasing the reserve requirement ratio can also help reduce money supply and liquidity in the economy.