Question

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

Short answer

As real GDP approaches potential GDP, the SRAS curve becomes steeper and steeper.

Step-by-step solution

Step 1. Inflation

Inflation is unpredictable in the short term. A greater rate of inflation usually happens during or shortly after a boom in the economy. Similarly, during recessions, inflation falls.

Step 2. Two ways in which inflationary price increases

The demand for inflationary price increases acts in two ways, as shown below:

1. The AD curve shifts to the right.

2. A shift to the left in the AS curve

When the economy is already experiencing near-potential GDP and full employment, a rightward shift in aggregate demand (AD) causes the price level to rise. As a result, prices rise and inflation rises. This occurs when aggregate demand rises to the point where aggregate supply from firms in the economy cannot be expanded owing to labor and capital being fully employed.

As a result, there is a scarcity of goods, resulting in an increase in the price level. A surge in input prices (such as oil and labor) that impacts all or most firms across the economy might be an alternate source. As a result, the AS curve shifts to the left, resulting in reduced real GDP, higher price levels, and inflation.

Step 3. LRAS and SRAS

The AD curve has shifted to the right in the diagram below. The potential GDP line is depicted by LRAS, while the short-term aggregate supply curve is depicted by SRAS.

In the graph above, a rightward movement of the AD (from AD₁ to AD₂) raises the price (from P₁ to P₂), putting inflationary pressure on the economy.

The AS curve has shifted to the left in the graph below.

In the graph above, a movement to the left of the AS curve (from S to S₁) causes the price to rise (from P to P₁), putting inflationary pressure on the economy.