Answer to Question #201563 in Microeconomics for May

Question

Assume the balance of aggregate demand and aggregate supply was broken by the changes in income of economic entities. How the balance may be restored? Demonstrate this with the aggregate demand and aggregate supply curves. Why the growth of aggregate demand may not lead to inflation?

Answer 1

With a fall in aggregate supply from As1 to As2 it leads to lower economic growth and pressure on prices.

To repair the balance, one needs to sell at a discount so as to clear unsold goods. The discount will increase the aggregate supply and it will go back to AS1

Growth of aggregate demand lead to temporary increase in real gross domestic product and employment as wags rise because of the tight labor. This will lead to increased price inflation as firms transfer the increased wages to the prices . The workers then realize of the situation and their interest to work for extra hours evaporates and real gross domestic product returns to normal with no inflation.