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Economics explained


Inflation and deflation

Aggregate demand and inflation

Aggregate demand and inflation

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A rise in aggregate demand will have a greater impact on the price level, the closer the economy comes to full capacity.

AD0 to AD1

The figure above shows that when aggregate demand shifts from AD0 to AD1, output can be raised from Y0 toY1 without increasing the price level.

This is because when output and hence employment are low, firms can attract more resources without raising their prices. There is time for input prices to change but, due to the low level of aggregate demand, they do not. For example, when unemployment is high, the offer of a job may be sufficient to attract new workers.

AD1 to AD2

When the aggregate demand curve shifts from AD1 to AD2, firms begin to experience shortages of inputs and bid up wages, raw material prices and the price of capital equipment. The price level thus rises from P1 to P2.

AD2 to AD3

As output reaches Y2, the economy is producing the maximum output it can make with existing resources. When aggregate demand shifts from AD2 to AD3 , there is a price rise from P2 to P3, inflation becomes a problem. Additional increases in demand lead to higher prices than output.

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