Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Demand-pull inflation
Show how an increase in aggregate demand creates demand-pull inflation. Explain why the effect on prices depends on spare productive capacity.
The economic idea
Inflation is a sustained increase in the general price level, measured as the percentage change in a representative price index over time. It reduces the purchasing power of money but does not imply that every price rises by the same proportion.
Demand-pull inflation occurs when aggregate demand increases faster than the economy can expand real output at current costs. It is commonly summarised as too much spending chasing the available output.
Aggregate demand can increase because consumption, investment, government expenditure or net exports rise. The multiplier may amplify an initial increase in autonomous spending, while the size of the price response depends on spare capacity and SRAS.
A rightward shift of AD raises the equilibrium price level in the AD–AS model. For this to become continuing inflation rather than a single price-level adjustment, aggregate demand must keep growing faster than productive capacity or inflation expectations must sustain the process.
Reading the current demand-side movement from AD₁ to AD₂
“Price level” measures the general price level and “Real GDP” measures real GDP. Inflation is inferred from a rise in the price level over time, not from its absolute height.
“AD₁” is the original expenditure schedule, “AD₂” is the current schedule, and “SRAS” is held fixed.
“E₁” records the initial price level “P₁” and output “Q₁”. “E₂” records the new price level “P₂” and output “Q₂” when the curves are distinct.
Starting equilibrium: E₁
“E₁” is where “AD₁” intersects “SRAS” before the shock.
The causal change: AD₁ to AD₂
“AD₂” lies to the right of “AD₁”. The price level rises from “P₁” to “P₂”, while real GDP rises from “Q₁” to “Q₂”.
What the price-level movement means
The current state is consistent with demand-pull inflation: stronger aggregate expenditure raises both the price level and short-run real output.
From stronger spending to inflationary pressure
Explain why spending rises before describing prices. For example, stronger consumer confidence may increase consumption, shifting AD right. Firms increase production, but tighter capacity and competition for inputs create upward pressure on costs and prices.
A higher price level in the new equilibrium shows a rise in average prices between two positions. Sustained inflation requires prices to keep rising over time; one AD shift alone does not establish that continuing process.
From autonomous spending to demand-pull inflation
A non-price determinant changes planned expenditure, moving aggregate demand from “AD₁” to “AD₂”.
At “P₁”, planned expenditure now exceeds output, so inventories fall and firms raise production and prices.
The economy moves along the unchanged “SRAS” until it reaches “E₂”.
“AD₂” lies to the right of “AD₁”. The price level rises from “P₁” to “P₂”, while real GDP rises from “Q₁” to “Q₂”. The current state is consistent with demand-pull inflation: stronger aggregate expenditure raises both the price level and short-run real output.
Common mistakes to avoid
- Demand-pull inflation is caused by a rightward shift of AD, not by movement along AD following a change in the price level.
- A rise in one product’s price is not inflation unless it contributes to a sustained increase in the general price level.
- The move from “Q₁” to “Q₂” is short-run actual growth, not necessarily an increase in productive capacity.
- The steeper SRAS is near capacity, the greater the price-level effect and the smaller the real-output effect of stronger demand.
How to draw this diagram
- Title the diagram “Demand-pull inflation”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD₁ first and label it clearly.
- Draw SRAS next and label it clearly.
- Draw AD₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram shows a price-level change, whereas inflation is a rate of change measured over time.
- It does not identify which component of AD increased or whether the change is temporary.
- The multiplier and price response depend on spare capacity, leakages, expectations and monetary conditions.
- Repeated demand growth may also encourage investment and productive capacity, shifting aggregate supply.
- The national price index conceals different inflation rates across households and products.