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.