Relationship between aggregate demand and inflation chart

Aggregate demand and aggregate supply curves (article) | Khan Academy

relationship between aggregate demand and inflation chart

Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement When an AD/AS diagram shows an equilibrium level of real GDP. Over time the levels of unemployment (UE), inflation (IN) and These fluctuations can be illustrated on a graph of the business cycle. Aggregate demand is the demand of all products in an economy - OR the relationship between the Price Level and the level of aggregate output (real GDP) demanded. The relationship between inflation developments and aggregate demand is usually between actual and potential output, which is generally proxied by trend.

Introduction To understand and use a macroeconomic model, we first need to understand how the average price of all goods and services produced in an economy affects the total quantity of output and the total amount of spending on goods and services in that economy.

Aggregate demand and aggregate supply curves

The aggregate supply curve Firms make decisions about what quantity to supply based on the profits they expect to earn.

Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy.

Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level. The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the diagram one at a time: The graph shows an upward sloping aggregate supply curve. The slope is gradual between 6, and 9, before become steeper, especially between 9, and 9, The aggregate supply curve.

The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy. It's an index number, like the GDP deflator. Wait, what's a GDP deflator again?

How the AD/AS model incorporates growth, unemployment, and inflation (article) | Khan Academy

The GDP deflator is a price index measuring the average prices of all goods and services included in the economy. Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well. Why do you think this is? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production.

The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain constant. In this diagram, you'll see a shift of aggregate demand to the right. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.

The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the right. The graph on the right shows two aggregate supply curves to represent a shift to the left. This situation can cause the aggregate supply curve to shift back to the left.

In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.

Demand pull inflation shown on the AS AD graph

It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years.

Why does inflation persist over time? One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the steep portion of the SRAS curve. A second possibility is that—if inflation has been occurring for several years—a certain level of inflation may come to be expected.

For example, if consumers, workers, and businesses all expect prices and wages to rise by a certain amount, then these expected rises in the price level can become built into the annual increases of prices, wages, and interest rates of the economy. Inflation is the rate of increase in the price level.

How the AD/AS model incorporates growth, unemployment, and inflation

But what happens to the price level? Normally we would expect the price level to decline from PL to PL' if AD decreases, but can you remember a time when the price level the average level of ALL prices in the economy decreased? It doesn't happen very often. Business are more willing to raise their prices causing more inflation than they are to decreases their prices causing deflation.

Economists call this the ratchet effect. Like a ratchet that only works in one direction, prices mores easily move in one direction up than in both. Sometimes it is said that prices are "stick downwards". On the graph then, if AD decreases instead of going from "a" to "b" less output and a lower price levelthe economy goes from "a" to "c" since prices are sticky downwards and tend not to decrease.

The causes of the ratchet effect are listed below. For several reasons businesses are reluctant to lower prices even when faced with lower aggregate demand. This would result in more unemployment and more inflation.

relationship between aggregate demand and inflation chart

We call this inflation "cost-push" inflation. It is inflation caused by a decrease in AS.

relationship between aggregate demand and inflation chart

Stagflation A decrease in AS results in "stagflation". It is caused by a decrease in AS. An increase in AS would increase output and lower the price level. This would result in less unemployment and less inflation.

Economic Growth What about economic growth? This is the definition we used in the 5 Es lesson.