Answer to Question #147622 in Macroeconomics for cynthia

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)

Answer 1

a) Demand pull inflation is a type of inflation caused by excess demand. It is usually associated with full employment equilibrium where the economy has little capacity to expand output: the rate of increase in demand exceeds the rate of increase in output. The diagram below lustrates demand pull inflation.

As shown on the diagram, an increase in aggregate demand beyond the full employment equilibrium, Yf, from AD1 to AD2 creates an inflationary gap. The general price level increases from P1 to P2, causing demand pull inflation if the increase persist.

b) Demand pull inflation may take place if:

• Employee wages increase when the economy is in full employment. Aggregate demand will increase with no significant increase in aggregate supply, creating an upward pressure on prices.
• Currency depreciation when the economy is in full employment may increase the volume of imports, exerting a pressure on local demand. Imports are a component of aggregate demand; their increase increases aggregate demand. Hence, in this scenario, they an increase in imports fuel demand pull inflation.
• Increase in government spending on goods and services when the economy is in full employment results in aggregate demand exceeding aggregate supply, which fuel up prices.

c) deflationary demand management policies must be instituted to curb demand pull inflation.

1. The government can increase income tax to offset an increase in employee wages and contain aggregate demand.
2. The government can raise export tarrifs to increase the cost of exported goods. This policy will raise the price of exports, resulting in a reduction in volume of imports and hence aggregate demand.
3. Government should consider cutting down on its expenditure to reduce aggregate demand.