What this lesson teaches
I can explain the causes of weak growth, unemployment, and inflation or deflation.
Syllabus 8843, 3.2.2(a). Macroeconomic Issues: Macroeconomic issues and their causes; Undesirable economic growth - persistently low or negative, unsustainable, non-inclusive due to factors such as changes in AD or AS, environmental degradation, inequitable income distribution; Unemployment - demand-deficient, structural, frictional due to factors such as lack of AD, technological changes, mismatch of skills, transition between jobs; Price instability - demand-pull inflation, cost-push inflation, deflation due to factors such as changes in AD, costs of production, productive capacity
Make a guess
The economy has many idle workers and factories, and spending rises strongly. Will prices rise a lot?
- Probably not. Output can rise using spare capacity.
- Yes. Any rise in spending causes high inflation.
- No, because prices are set by firms, not by spending.
Show the answer
Probably not. Output can rise using spare capacity.
With spare resources, firms can produce more without bidding up costs. Demand-pull inflation is a risk near full capacity.
When AD grows faster than the economy can produce, prices are pulled up.
Demand-pull inflation happens when AD rises while the economy is near full capacity.
Firms cannot raise output much, because workers and machines are already fully used. So they raise prices instead.
Causes include a boom in consumer spending, strong exports, rising investment or large increases in government spending.
If the economy has plenty of spare capacity, a rise in AD mostly raises output instead, with little inflation.
- Cause
- AD rises near full capacity.
- Effect
- Prices rise; output rises a little.
Worked example: Spending meets limited capacity
Households and firms raise spending across the economy, while factories, transport and skilled workers are already stretched.
- AD rises.
- Firms cannot quickly raise output, so shortages appear.
- They raise prices and compete for scarce workers, pushing up wages.
- The price level rises: demand-pull inflation.
Watch out for this
Any rise in AD causes inflation.
With spare capacity, a rise in AD mainly raises output. Inflation is a risk near full capacity.
Check your understanding
When is a rise in AD most likely to cause high inflation?
- When the economy is close to full employment.
- When unemployment is high and many people want to spend more.
- During a deep recession, when firms hold a lot of unsold stock.
Show the answer
When the economy is close to full employment.
Right. Output cannot rise much, so prices rise instead.