Question

SUBJECT: ECONOMICS:

QUESTION FOUR:

4.1 Assume the aggregate demand of an economy is rising at 3%, but its productive capacity is only rising at 2%. Discuss the type of inflation this would lead to. Use a diagram to motivate your answer.    

Answer 1

The type of inflation this would lead to is demand-pull inflation.

Explanation:

The type of inflation this would lead to is demand-pull inflation because the aggregate demand of an economy is rising at 3% but its productive capacity is only rising at 2%, which means that the aggregate demand is rising more than the productive capacity which is also called as the supply. More demand increase and less supply increase means that the price is rising due to greater demand than the supply. So, this type of inflation is called as demand-pull inflation.

In the diagram below, I have drawn Price on the vertical axis and Quantity of the horizontal axis. The initial demand and supply curve is denoted by Demand and Supply respectively. After the demand have increased, the demand curve shifted to the right to Demand1 and after the supply increase, the supply curve shifted to the right to Supply1. But, since the increase in demand is greater than the increase in supply (3% > 2%), the magnitude of the shift in the demand curve is more than the magnitude of the shift in the supply curve.

The initial equilibrium price is P0 and the initial equilibrium quantity is Q0. After the change in demand and the supply curves, the equilibrium price has increased to P1 and the equilibrium quantity has increased to Q1.