Answer to Question #131987 in Microeconomics for Sme

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

Demand-Pull-inflation

Whenever aggregate demand (AD) of an economy exceeds its productive capacity, the type of inflation that results is known as demand-pull inflation. As such, in an economy where aggregate demand is rising at 3 %, while the productive capacity is rising at only 2 %, firms within this economy tend experience a higher demand that outstrips their supply. In this scenario, firms respond by increasing their prices, causing demand-pull inflation. Ideally, demand-pull inflation represents a case of excess demand where too much money happens to chase too few goods. 

Graphically, demand-pull inflation is succinctly show by a graph of price (p) against real gross domestic product (Y), where aggregate demand (AD) is seen increasing faster than aggregate supply (AS) as follows.

                                              

From this graph we can see shift in aggregate demand (AD) from AD ¹ to AD ² is greater than productive capacity as represented by the long-run aggregate supply (LRAS) curve as shown by the movement along the LRAS curve from point A to B. The increasing in AD from AD ¹ to AD ² and the increase of productive capacity (LRAS) from point A to B, simultaneously increases real GDP from Y ¹ to Y ² and price level from P ¹ and P ², thus causing inflation. From the graph, the proportionate increase in real GDP is relatively smaller than that of the price level thus indicating the smaller growth in an economy’s productive capacity represented by the LRAS curve as opposed to bigger increase in AD as captured by the significant increase in AD as shown by the shift from AD ¹ to AD ². Therefore, it is clear, if aggregate demand (AD) increases faster than the productive capacity (LRAS), then firms respond by increasing prices because AD is greater than AS, thus causing demand-pull inflation.