Just Keynesian

November 22 year 2014

4b) Discuss whether inflation is more likely to be caused by a shift in an

economic’s  aggregate  demand  or  shift  in  its  aggregate  supply  (12)

Answer:

Note: AD=Aggregate Demand, RGDP= Real Gross Domestic Product, SRAS=Short run aggregate supply, PL=Price level

Inflation is the a general increase in the price level of goods in the a country. It causes the purchasing power to decrease as the people are now able to purchase lesser goods with the same amount of money as before. A decrease in purchasing power also means a fall in the real value of money that the money is now worth less. There are 2 two main Inflations which is are demand pull inflation (Shift in AD) and cost push inflation (Shift in SRAS)

Firstly Demand pull inflation is caused by an increase in the AD as a whole in the country; when there is an increase in AD increases both the price level and the RGDP will increase as shown in the diagram 1. (Shown in diagram 1). There are many causes of increase in AD. When Increase in consumer spending, government spending, investment and net export increases this will cause AD to shift right, and incurring demand pull inflation therefore PL increase and RGDP increase. Same goes for import, when import decrease PL and RGDP too will  increase  because  when  people  don’t  buy  imported  goods  they  buy  domestic goods. Not only that, AD can also increase when there is an excess increase in money supply. Higher money supply is likely to increase the nominal income of consumers for when causing them to increase the demand on goods and services the consumer has more money (Given that they are rational), demand will increase

Second cause of inflation is Cost push inflation which is cause by a decrease in SRAS, diagram 2 shows that when SRAS decrease, PL increases but RGDP decreases (Shown in diagram 2). There are many causes of decrease in SRAS and but it is mostly is due to the reduction in raw materials and an increase in the cost of production. Example: when there is increase in the prices of raw materials (government taxation, higher imported price), when there is a natural disaster causing the supply of goods to decrease, when the increase in the wage rate is more than increase in productivity etc.

To know answer the question which inflation is more likely to happen, it is useful to analyze we are to see which are the variables that fluctuate more often of the causes are easier to affect the shift in AD and SRAS. As a comparison, we could see that consumer spending, government spending,

investment, export and import are more likely to happened change compared to changed in raw material and the cost of production. This is because the expenditure behavior of various agents in an economy is sensitive to the change of economic conditions and thus the change in their expenditure can be volatile. The fluctuation of cost of production in an economy can be very minimal. because in short run the price cannot change immediately and it may also First, due to sticky wage the cost of labour is expected to be stable in short run. and as the above example of Second, natural disasters can affect the supply of raw materials but they do not happen frequently. it will not always happen and cause supply to decrease. Third, producers at large have much concern about the cost of production and will take various measures to hedge against the increase in of price of raw materials. Therefore in Since conclusion the shift of AD is more likely to happened, it is concluded and this also means that demand pull inflation are more likely to happen than compared to cost push inflation.

(Demand pull inflation)

(Cost push Inflation)

Attention:

If you have mentioned diagram 1 and 2 in your essay, make sure that you label your diagrams accordingly.

November 23 Year 2014

3a) Explain why an increase in the money supply and rising world energy

prices are categorized as different causes of inflation in an economy (8)

Answer:

Note: AD=Aggregate Demand, RGDP= Real Gross Domestic Product, SRAS=Short run aggregate supply, PL=Price level

Inflation is a general and sustained increase in prices. There are few types of Inflation that are categorized differently due to the different of based on the cause of the inflation.

Firstly there is inflation called Demand pull inflation, This is an inflation which happens occurs when there is due to an increase in the total demand for goods and services on economy when the economy is at or close to maximum capacity.

There are also an inflation called the Monetary inflation, this is caused by an increase in the money supply which decrease the real value of the money and cause an increase in general price level. Monetary inflation is also related to can trigger demand pull inflation because as people hold more money they tend to buy more increase their demand, leading and this will lead back again to demand pull inflation. When the increase in the AD is not matched by an equivalent increase in AS, price level will increase, these impacts are shown in diagram 1and RGDP will also increase (Drawn in diagram 1).

Another inflation is called Cost push inflation, this inflation is caused by an increased in the cost of production. A rise in world energy prices would increase the cost of production and therefore it is categorized as cost push inflation. As the minimum supply price that sellers request increases, SRAS curve shift leftward and this cause the PL to increase and the RGDP to decrease, as shown in diagram 2 (Drawn in diagram 2)

In conclusion, an increase in money supply increases AD, more than AS of the economy therefore causing both PL and RGDP increase if the increase of AD outweighs the increase of AS, the increase in money supply leads to monetary inflation. while An increase in world energy prices increases the cost of production and leads to cost push inflation decreases the AS of an economy causing PL to increase and RGDP to decrease. Inflation caused by an increase in money supply is different from inflation caused by the rising world energy prices because they are affected triggered by different factors: the increase in money supply and the increase in cost and these factors can be monetary factors, demand pull factors or cost push factors.

Attention:

If you have mentioned diagram 1 and 2 in your essay, make sure that you label your diagrams accordingly.