Question

How is pressure for inflationary price increases shown in an AD/AS model?

Short answer

In the AD/AS model, pressure for inflationary price increases is shown through the interaction between aggregate demand and short-run aggregate supply, leading to a higher equilibrium price level. This can be caused by factors such as an increase in government spending, an expansionary monetary policy, or a decrease in short-run aggregate supply. The process involves shifts in the AD and SRAS curves, ultimately resulting in a higher overall price level and inflationary pressure in the economy.

Step-by-step solution

Define the AD/AS Model

The Aggregate Demand/Aggregate Supply (AD/AS) model is a macroeconomic model that represents the interaction between aggregate demand and aggregate supply in an economy. It is used to analyze economic growth, inflation, and unemployment, and to illustrate how fiscal and monetary policies can affect an economy's overall performance. The model consists of two curves: the Aggregate Demand (AD) curve and the Aggregate Supply (AS) curve.

Describe the Aggregate Demand Curve

The Aggregate Demand (AD) curve represents the total quantity of goods and services demanded by households, businesses, and the government in an economy at various price levels. The AD curve slopes downward, which means that as the general price level falls, the quantity of goods and services demanded increases. This relationship is due to the wealth effect, the interest rate effect, and the international trade effect.

Describe the Aggregate Supply Curve

The Aggregate Supply (AS) curve represents the total quantity of goods and services that firms in an economy are willing and able to supply at various price levels. There are two types of AS curves: short-run and long-run. The short-run aggregate supply (SRAS) curve slopes upward because in the short run, firms can increase output (and prices) in response to higher demand, without significantly changing their production capacity. In contrast, the long-run aggregate supply (LRAS) curve is vertical because it represents the potential output of an economy at full employment, regardless of the price level.

Identify Inflationary Price Increases in the AD/AS Model

Inflationary price increases occur when the general level of prices in an economy is rising. In the AD/AS model, this can be shown as an increase in the price level (measured on the vertical axis) and a movement along the SRAS curve. Inflationary pressure arises from an increase in aggregate demand or a decrease in short-run aggregate supply (or both), which leads to a higher equilibrium price level.

Explain the Process Leading to Inflationary Price Increases

To demonstrate how inflationary price increases are shown in the AD/AS model, let's consider an example. Suppose that there is an increase in government spending or an expansionary monetary policy, which raises aggregate demand. As a result, the AD curve shifts to the right. At the initial price level, firms experience a higher demand for their goods and services and respond by increasing output, but they also face higher input costs. In the short run, firms are willing to supply more at higher prices, which leads to increased production and higher overall prices (inflation). In the meantime, the long-run equilibrium is disrupted. Eventually, the higher price level, higher costs of production, and higher wages lead to a decrease in short-run aggregate supply. The SRAS curve shifts to the left, restoring the long-run equilibrium at a higher price level, which demonstrates the inflationary pressure in the economy. In conclusion, pressure for inflationary price increases is shown in the AD/AS model through the interaction between aggregate demand and short-run aggregate supply, which leads to a higher equilibrium price level. This can be caused by an increase in aggregate demand or a decrease in short-run aggregate supply (or both).