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PROBLEMS OF INFLATION AND UNEMPLOYMENT Problems of Inflation Inflation is an increase in the overall price level. Keeping inflation low has long been a goal of government policy. Types of inflation 1. Demand-Pull Inflation Inflation initiated by an increase in aggregate demand is called demand-pull inflation. In both figure 1 and figure 2, the inflation begins with a shift of the aggregate demand schedule from AD0 to AD1, which causes the price level to increase from P0 to P1. (Output also increases, from Y0 to Y1). If the economy is operating on the steep portion of the AS curve at the time of the increase in aggregate demand, as in figure 2, most of the effect will be an increase in the price level instead of an increase in output. If the economy is operating on the flat portion of the AS curve, as in figure 1, most of the effect will be an increase in output instead of an increase in the price level. 2. Cost-Push Inflation Inflation can also be caused by an increase in costs, referred to as cost-push inflation. An increase in costs (a cost shock) shifts the AS curve to the left, as figure 3 shows. If we assume the government does not react to this shift in AS by changing fiscal or monetary policy, the AD curve will not shift. The supply shift will cause the equilibrium price level to rise (from P0 to P1) and the level of aggregate output to decline (from Y0 to Y1). Stagflation occurs when output is falling at the same time prices are rising-in other words, when the economy is experiencing both a contraction and inflation simultaneously. Figure 3 shows that one possible cause of stagflation is an increase in costs. The government could counteract the increase in costs by engaging in an expansionary policy. This would shift the AD curve to the right, and the new AD curve would intersect the new AS curve at a higher level of output. The problem with this policy, however, is that the intersection of the new AS and AD curves would take place at a price even higher than P1 in figure 3.
Approximate Word count = 1436
Approximate Pages = 5.7
(250 words per page double spaced)
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