Question

Define demand-pull inflation. Using the AS/AD model, explain how demand-pull inflation affects the level of aggregate output and the price level in the economy (which curve shifts, in what direction, and what happens to equilibrium output and price level). Give an example of macroeconomic policy that can be used to counter the effects of demand-pull inflation and discuss its effect on the equilibrium output and price level.

Answer 1

A demand pull inflation is when increase in aggregate demand (more than aggregate supply) pushes prices upwards causing inflation. Basically there are too many dollar bills chasing a lesser number of goods & services - which raise prices.

This is demonstrated in the graph through an increase in AD from AD1 to AD2. The AD curve shifts right. This leads equilibrium prices to be higher at P2 from P1. While equilibrium output increases along the AS curve from e1 to e2 and new output is Y2.

A macroeconomic policy that can curb the demand pull inflation would be contractionary fiscal policy. A contractionary fiscal policy like decrease in government purchases (will decrease output and prices to original level through multiplier effect). The impact of a contractionary fiscal policy will be a leftward shift in AD curve. When G falls, AD falls. AD returns from AD2 to AD1. This causes output and prices to return to Y1 and P1. The amount of decrease in G has to be decided based on the output gap and the mpc (multiplier) of the economy.