Using the monetarist/new classical model and the Keynesian model, discuss the view that increases in aggregate demand will inevitably be inflationary.
Definitions
- Aggregate Demand (AD): The total spending in an economy at a given price level over a period of time, calculated as AD = C + I + G + (X - M).
- Inflation: A sustained increase in the general price level of goods and services in an economy over time.
- Monetarist/New Classical Model: A model that assumes the economy operates at full employment in the long run, with AS being vertical at potential output.
- Keynesian Model: A model that suggests the economy can experience unemployment and spare capacity in the short run, allowing AD to increase without necessarily causing inflation.
Diagram
- In the Monetarist/New Classical AD-AS Model, LRAS should be vertical at full employment output.
An increase in AD always leads to demand-pull inflation as the economy is assumed to be at full capacity.
- In the Keynesian AD-AS Model, AS has three sections: Keynesian (horizontal), Intermediate (upward sloping), and Classical (vertical). An increase in AD may not cause inflation if the economy is operating below full employment (in the horizontal section). Inflation only occurs in the intermediate and classical sections.
Explanation
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In the Monetarist/New Classical view, the economy is assumed to operate at full employment in the long run. Any increase in AD always leads to higher prices, as LRAS is vertical. This results in demand-pull inflation, with no increase in real GDP.
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The rightward shift of AD in the monetarist model leads to an increase in the price level but no real GDP growth. This supports the view that AD increases will inevitably be inflationary.
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In the Keynesian view, the economy can have spare capacity (horizontal AS section).
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If AD increases while the economy is below full employment, only real GDP increases, without inflation.
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However, as AD continues rising, reaching the intermediate section, both real GDP and price levels rise. Once full employment is reached (classical section), further AD increases only cause inflation, as AS is now vertical.
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The impact of AD increases depends on where the economy is on the Keynesian AS curve. This suggests that AD increases do not always lead to inflation.
Using real-world examples, evaluate the view that increases in aggregate demand will inevitably be inflationary.
Definitions
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Aggregate demand (AD): The total demand for goods and services in an economy at a given price level and in a given period of time, calculated as AD = C + I + G + (X-M).
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Inflation: A sustained increase in the general price level of goods and services in an economy over a period of time.
Economic Theory
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When aggregate demand increases (e.g., due to expansionary fiscal or monetary policy), firms respond by increasing output to meet demand.
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In the short run, firms utilize existing resources more efficiently, increasing output with minimal price increases.
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As AD continues to rise, firms reach capacity constraints, leading to higher costs of production (e.g., wages, raw materials), pushing up prices.
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Demand-pull inflation occurs as firms pass increased costs onto consumers.
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If the economy operates near full employment (as observed in Diagram 1), the price level rises significantly with limited output increase.
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In the long run, inflation expectations may lead to a wage-price spiral, reinforcing inflationary pressures.
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If AD increases while aggregate supply (AS) is also increasing (due to productivity growth or investment in capital), inflationary pressures may be reduced.
Diagram
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AD/AS model shows an increase in AD shifting the AD curve rightward (AD1 to AD2), leading to a higher price level (P1 to P2) and potential output increase (Y1 to Y2), causing an inflationary gap.
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If the economy is at or near full employment, price levels rise sharply with minimal output growth.
Evaluation
- Households may face reduced purchasing power if wages do not increase proportionally, while businesses could benefit from increased sales but struggle with rising costs.
- Governments may experience higher tax revenues but will also face pressures to control inflation.
- In the short run, AD increases can boost growth and employment, but in the long run, sustained inflation might create uncertainty, reducing investment and long-term economic stability.
- Although demand-driven growth can lower unemployment and stimulate economic activity, unchecked inflation can erode savings, reduce international competitiveness, and distort economic decision-making.
- The impact of AD growth on inflation ultimately depends on factors such as spare capacity, productivity improvements, and supply-side policies.
- A real-world example is the U.S. economy during 2021-2022, where stimulus-induced AD growth led to inflation rising from 1.4% (2020) to 7.0% (2021) and 9.1% (mid-2022) due to supply chain constraints and increasing labor costs.
- The Federal Reserve’s response through interest rate hikes illustrates how policy measures can mitigate inflationary pressures stemming from excessive AD growth.
Conclusion
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Increases in AD can be inflationary, especially when the economy is near full employment.
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The extent of inflation depends on supply-side conditions, policy responses, and external factors.
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Inflationary pressures from AD growth can be managed through supply-side policies and monetary interventions.
