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 can be shown as an upward shift in the Aggregate Demand (AD) curve (demand-pull inflation) or the Short-run Aggregate Supply (SRAS) curve (cost-push inflation). When either of these curves shift upwards, the equilibrium price level increases, representing the pressure for inflationary price increases in the economy. Demand-pull inflation occurs when aggregate demand increases due to factors such as increased consumption, investment, government spending, or net exports, while cost-push inflation occurs when production costs rise due to factors like higher wages or raw material costs.

Step-by-step solution

1. Understanding the AD/AS Model

The AD/AS model is used in macroeconomics to represent the relationship between the aggregate demand and aggregate supply in an economy. It illustrates the equilibrium between the total quantity of goods and services demanded (AD) and the total quantity of goods and services supplied (AS) at different price levels. Aggregate Demand (AD) is the total demand for all goods and services in an economy at a given price level and given time period. It is composed of consumption, investment, government spending, and net exports (exports minus imports). The AD curve slopes downwards, indicating that as the price level decreases, the quantity of goods and services demanded increases. Aggregate Supply (AS) is the total supply of all goods and services in an economy at a given price level and given time period. There are two types of Aggregate Supply curves: 1. Short-run Aggregate Supply (SRAS) - This curve represents the supply side in the short term and is upward sloping, indicating that as the price level increases, firms are willing to produce more goods and services. In the short run, production can be increased due to flexible prices, wages, and available resources. 2. Long-run Aggregate Supply (LRAS) - This curve represents the supply side in the long term and is vertical, indicating that the economy's potential output does not depend on the price level. In the long run, the production capacity of an economy is determined by factors such as technology, available resources, and labor force participation.

2. Identifying Inflationary Price Increases in AD/AS Model

Inflationary price increases occur when there is a persistent rise in the general price level in an economy. In the AD/AS model, this can be shown as an upward shift in the AD curve or the SRAS curve, causing the general price level to rise. There are primarily two causes of inflationary price increases: 1. Demand-pull inflation: This occurs when there is an increase in aggregate demand due to factors such as increased consumption, investment, government spending, or net exports. This leads to an upward shift in the AD curve, causing the equilibrium price level to rise and resulting in inflation. 2. Cost-push inflation: This occurs when the cost of production increases due to factors such as higher wages, increased taxes, or higher raw material costs. This leads to an upward shift in the SRAS curve, causing the equilibrium price level to rise and resulting in inflation.

3. Showing Pressure for Inflationary Price Increases in AD/AS Model

To show the pressure for inflationary price increases in the AD/AS model, follow these steps: Step 1: Draw the initial AD/AS graph with AD, SRAS, and LRAS curves, and label the initial equilibrium point as E1 at price level P1 and output level Y1. Step 2: For demand-pull inflation, shift the AD curve to the right (upwards) from AD1 to AD2, indicating an increase in aggregate demand. This results in a new equilibrium point E2 at a higher price level P2 and higher output level Y2. Step 3: For cost-push inflation, shift the SRAS curve to the left (upwards) from SRAS1 to SRAS2, indicating an increase in production costs. This results in a new equilibrium point E2 at a higher price level P2 and lower output level Y2. In both cases, the equilibrium price level increases from P1 to P2, representing the pressure for inflationary price increases in the economy.

Key concepts

Aggregate Demand

Aggregate Demand represents the total demand in an economy for all goods and services. It aggregates the spending and purchasing behaviors of households, businesses, government, and foreign markets (net exports). The aggregate demand curve typically slopes downward. This means as prices drop, people are more inclined to buy more. The formula for aggregate demand is often expressed as: \( AD = C + I + G + (X - M) \). Here:
\( C \) is consumption by households
\( I \) is investment by businesses
\( G \) is government spending
\( (X - M) \) is net exports (exports minus imports)
Aggregate demand reflects economic activity and can be influenced by several factors, such as changes in consumer confidence, fiscal policies, and interest rates. When any of these components increase, aggregate demand can shift upward, leading to potential economic growth.

Aggregate Supply

Aggregate Supply is how much the economy can supply at various price levels. It includes everything from consumer goods to capital equipment. In the short term, the aggregate supply curve (SRAS) slopes upward. This shows that, in the short run, as prices increase, companies will typically produce more. This is often because they can adjust some costs like labor quickly and increase production.
In contrast, the long-run aggregate supply curve (LRAS) is vertical. It indicates that over time, the economy reaches its capacity to produce. Changes in aggregate supply can result from factors such as technological advancements, changes in resource availability, and improvements in workforce skills. An upward shift in aggregate supply means that more goods and services can be provided at each price point, usually resulting in lower inflationary pressure.

Demand-pull inflation

Demand-pull inflation occurs when the demand in an economy outpaces supply, causing prices to increase. It typically happens when an economy experiences strong economic growth. Imagine a booming job market or a surge in consumer and business investment. These conditions boost spending and push the aggregate demand curve to the right. When the demand is high and supply cannot immediately match it, prices go up, leading to inflation.
This type of inflation is often seen in actively growing economies. It's a sign that demand exceeds what's available, forcing businesses to raise prices. Governments might use monetary or fiscal policies to manage demand-pull inflation by cooling down economic activity.

Cost-push inflation

Cost-push inflation arises when the costs of production increase, which leads to a decrease in the supply of goods and services. Businesses may face higher costs due to factors like increased wages, higher taxes, or expensive raw materials. This scenario forces the short-run aggregate supply curve to shift to the left. Consequently, at the same demand level, prices rise because there's less supply available.
Cost-push inflation is often uncomfortable for economies because it can cause a slowdown in economic growth. Prices rise, but the output may fall or stagnate, leading to inevitable inflation even when the economy is not necessarily overheated by high demand. This scenario requires careful handling by policymakers to avoid sparking wage-price spirals where prices and wages increase in a continuous cycle.