HL Economics

14 Macroeconomic Objective: Low Inflation

1) Use an AD/AS diagram to explain two possible causes of demand-pull inflation.Screen shot 2013-04-11 at 11.10.47 AM

Demand-pull inflation is “an increase in the prices arising from the increased overall demand for a nation’s output when consumption, investment, government spending or net exports rises, without a corresponding increase in the level of AS.” It can also be restated as the average price of goods and services in a nation rises, as there are too many consumers chasing too few goods. Two causes of demand-pull inflation include increase in consumption and investment, which will increase the competition amongst consumers for the limited supply of goods thus increasing price levels(P0-P1) as well as the national output (Y0-Y1). The large increase in the national output, compared to that of the increase in price level is evident due to the SRAS being inelastic around the full-employment level of output as almost all resources are fully employed. Thus, with an increase in AD, there is a smaller change in the national output, in contrast to the price level which causes this demand-pull inflation to occur. For countries like Japan, in which their economy is in a recession, their output of full-employment level and price level will start from a fairly low position, towards the bottom left. Because the country’s in a recession, they have a low demand yet have large quantities of resources (land, labor, capital). Thus, in an increase in consumption (AD), the price level may show a small increase in contrast to a large increase to the right in the output level. As labor is cheaper because of the surplus of labor and capital, the producers are willing to invest more in the capital. With the demand-pull inflation, Japan could show an inflation but it will be controlled as the SRAS is elastic below the full employment which suggests an increase in consumption (AD) can increase the national output greatly without erupting a great inflation.

b) Assuming a government takes no action to control demand-pull inflation, examine the likely effect it will have on a nation’s economy in the long run. 

Demand-pull inflation is when the average price of goods and services in a nation rises, due to limited resources and excess of consumers. Without the government taking action to control the demand-pull inflation, the likely effect it will have on a nation’s economy in the long run includes the increase in price level and decrease in employment. In the short run, the excessive increase in inflation could cause the loss of purchasing power, lower real interest rates for savers, higher nominal interest rates for borrowers, and reduction in international competitiveness. As the demand increases and the price level rise as the household continues to maintain the same or slower rate in the rise of their income, there will be a loss in purchasing power. As for the interest rates, the savers will be negatively impacted as the inflation will cause a decrease in the real value of savings. Thus, investments may decrease as the inflation has caused the real interest rates for savers to decrease. There is a reduction in international competitiveness (imports, exports) as well because exports become less attractive to foreigners as inflation increases the price levels, and imports become more attractive to the domestic consumers as prices of goods and services are cheaper outside of the country. This would cause the country’s towards a deficit as the demand for exports decrease and increase in demand for cheaper imports are made. With this, it would result in a reduction in consumption as well as loss of jobs in the exporting industry. In the long run, the demand-pull inflation could lead to a cost-push inflation (which is called an inflationary spiral) and this is known to be a threat to the economy.

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