Question

Define cost-push inflation. Using the AS/AD model, explain how cost-push inflation affects the level of aggregate output and the price level in the economy. Suppose that the government uses expansionary fiscal policy to counter the effects of the cost-push inflation. Indicate using the AS-AD model the impact of this policy on the price level and level of aggregate output.

Answer 1

Cost-push inflation occurs due to an increase in price level brought about by an increase in cost of inputs and factors of production. At higher input costs, firms lower production which decreases aggregate supply, which shifts short-run aggregate suppl (SRAS) curve, increasing price level and decreasing output. To counter the effects, if expansionary fiscal policy is implemented, it increases aggregate demand and AD curve shifts right to intersect new SRAS curve. This restores output to its original level but further increases price level, spiralling the inflationary effect

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (which is equal to Potential GDP) Y0. Higher input costs will shift SRAS0 leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP & output Y1, causing stagflation. An expansionary fiscal policy will shift AD0 rightward to AD1, intersecting SRAS1 at point C with real GDP being restored at initial level of Y0, but price level being further higher at P1.