Applying AD-AS analysis to inflation

Overview

Wage-price spiral be shown on an AD-AS diagram and policy dilemma created by a supply shock.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Use AD-AS analysis to explain demand-pull inflation.

   Model answer

   Demand-pull inflation occurs when aggregate demand rises faster than the economy's ability to produce. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the aggregate demand curve shifts right along an upward-sloping aggregate supply curve, so the equilibrium moves up and to the right: the general price level rises and real national output rises. The closer the economy is to its long-run aggregate supply position, the steeper the curve and the greater the share of the increase that shows up as inflation rather than output.

2. 2

   Use AD-AS analysis to explain cost-push inflation.

   Model answer

   Cost-push inflation occurs when firms' costs of production rise, for example through higher wages, energy prices or imported input costs. The short-run aggregate supply curve shifts upwards and to the left, so on a diagram with the general price level on the vertical axis and real national output on the horizontal axis the equilibrium moves up and to the left along the aggregate demand curve. The general price level rises while real national output falls, so inflation is accompanied by rising unemployment rather than by a boom.

3. 3

   How can a student tell from output data whether an episode of inflation is demand-pull or cost-push?

   Model answer

   The direction of the output change distinguishes them. Demand-pull inflation comes from a rightward shift of aggregate demand, so the general price level and real national output rise together and unemployment falls. Cost-push inflation comes from a leftward shift of short-run aggregate supply, so the general price level rises while real national output falls and unemployment rises. Rising prices alongside falling output therefore point to a supply-side cause.

4. 4

   A price index rises from 105 to 108.15 over a year. Calculate the rate of inflation and state what the AD-AS diagram would need to show.

   Model answer

   Inflation = (108.15 - 105) / 105 = 3.15 / 105 = 0.03, or 3.0 per cent. The diagram, with the general price level on the vertical axis and real national output on the horizontal axis, would need the equilibrium price level to move from 105 to 108.15. Whether that came from a rightward shift of aggregate demand or a leftward shift of short-run aggregate supply would be revealed by whether real national output rose or fell over the same period.

5. 5

   Apply AD-AS analysis to explain why the same rise in aggregate demand can be inflationary in one economy and not in another.

   Model answer

   The outcome depends on where the aggregate demand curve crosses the aggregate supply curve. In an economy with a large negative output gap the intersection is on the flat part of the supply curve, where idle labour and machinery can be brought into use without bidding up costs, so the shift raises real national output with little change in the general price level. In an economy already at or near its long-run aggregate supply position the intersection is on the steep or vertical part, so the same shift raises the general price level with little or no gain in output. The amount of spare capacity, not the size of the stimulus, decides the split.

6. 6

   How can a wage-price spiral be shown on an AD-AS diagram?

   Model answer

   An initial leftward shift of the short-run aggregate supply curve raises the general price level and lowers real national output. Workers whose real pay has been eroded bargain for compensating money wage increases, which raise firms' costs further and shift the short-run aggregate supply curve left again, raising the price level once more. Each round repeats the process, so with the general price level on the vertical axis and real national output on the horizontal axis the supply curve ratchets leftwards and the price level climbs while output stagnates. The spiral is sustained by expectations, which is why anchoring them is central to controlling inflation.

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