Question

Briefly describe the situation in an economy due to inflationary pressure. Use the AD-AS model to graphically depict an inflationary gap in the economy.also add graph.

Answer 1

Ans: When the short run equilibrium output is the right side of long run equilibrium then economy faces inflationary pressure. In the short run, the equilibrium level of output can be more than or less than the long run equilibrium output. When the short run equilibrium output is more than the long run equilibrium output level, then it is said to create inflationary pressure in the economy. In the following diagram, AD is intersecting the short run As curve at e₀ point where output is more than the long run equilibrium level. The aggregate supply is more than the long run aggregate supply. Therefore, the competition among buyers will emerge, they will push up the prices by offering higher prices. The price starts rising from P₀ to P₁. Due to price rise, some aggregate demand is decreased because not all can afford the goods and services at higher prices. So, the long run equilibrium is achieved at Y^* level.