Inflationary Pressures in the AD/AS Diagram

Inflationary Pressures in the AD/AS Diagram

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.

The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is 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 figure (a), there is a shift of aggregate demand to the right; the new equilibrium E₁ is clearly at a higher price level than the original equilibrium E₀. 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.

Sources of Inflationary Pressure in the AD/AS Model

(a) A shift in aggregate demand, from AD₀ to AD₁, when it happens in the area of the SRAS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. (b) A shift in aggregate supply, from SRAS₀ to SRAS₁, will lead to a lower real GDP and to pressure for a higher price level and inflation. The new equilibrium (E₁) is at a higher price level (P₁), while the original equilibrium (E₀) is at the lower price level (P₀).

An alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left. In figure (b), the shift of the SRAS curve to the left also increases the price level from P₀ at the original equilibrium (E₀) to a higher price level of P₁ at the new equilibrium (E₁). 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.

The AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. There are two explanations for why inflation may 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. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.