Question

It is sometimes argued that economic growth that is "too rapid" will be associated with inflation....

  1. It is sometimes argued that economic growth that is "too rapid" will be associated with inflation. Use the Aggregate Demand and Aggregate Supply model to show and explain how this statement might be true. When this claim is made, what type of shock is implicitly assumed to be hitting the economy?

    [NB: In your explanation include what happens to output, consumption, unemployment rate, investment and the price level]

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Answer #1

Starting form the point A. The output is at the potential level, an increase in the demand will increase the price level to P and the output to Y. this increase will create an inflationary pressure in the market. Due to rising demand and inflation the price will rise and unemployment will decrease. at this level the real wage is low.

The economy will be facing a positive demand shock and that will shift the AD curve to the right. this increase in the output was not possible with out an increase in the inflation after reaching the potential output level.

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