Demand Pull Inflation in the AD/AS Model

Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression. Even during the relatively short recession of 1991–1992, the rate of inflation declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short recession of 2001, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the rate of inflation declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher or lower; instead, it has stayed in the range of 1–5% annually.

Demand Pull inflation will occur if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve.

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.  In this situation ‘too many dollars are chasing too few goods’ and an inflationary gap exist in the difference between the current equilibrium GDP and the full employment or potential GDP.

Stagflation, a Combination of Recession and Cost Push Inflation in the AD/AS Model

This macro failure combines the two harmful consequences of the business cycle:  inflation and high unemployment.  It occurs with a fall of the Aggregate Supply and a equilibrium GDP now below full employment GDP, thereby creating a recessionary gap, cyclical unemployment and inflation.  Stagflation is often due to a ‘supply shock’ or sudden and significant rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—which causes 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 called Cost Push inflation.