Question

When the economy approaches full employment, why does demand pull inflation become a problem?

Answer 1

When aggregate demand for goods and services exceeds aggregate supply of output
which is produced by fully employing the given resources of an economy, excess
demand is said to occur. This excess demand leads to the rise in general price
level i.e. inflation in the economy. Before full employment of resource is
reached, any rise in aggregate demand will cause aggregate supply of output to
rise. Rise in production of output is followed by more employment and income.
The rise in the general price is followed by rising employment and income. But
after full employment resources in the economy, the productive resources are
exhausted thus any rise in demand will not raise supply of output. Production of
output remains constant but due to constant rise in aggregate demand price level
will tend to rise. This rise in price levels is called true inflation according
to Keynes. In such a case rise in aggregate demand is the cause of inflation.
This type of inflation is called demand-pull inflation.The demand-pull inflation
may be defined as a situation where the aggregate demand exceeds the economy's
ability to supply the goods and services at the current prices, so that the
prices are pulled upward by the upward shift of demand function