Page 176 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 10: Theories of Inflation

If government decides to incur an expenditure, G, the aggregate expenditure curve (C+1+G) Notes
shifts upwards and new equilibrium is D where the level of income is Y, and expenditure E.
However, suppose Y is full employment equilibrium and the real output cannot increase. Thus
0
there is an excess demand equal to AB which will be purely inflationary and this represents the
inflationary gap (Keynesians recommend that in such situations the government should follow
deflationary policy to bring down aggregate demand to the equilibrium level).
Figure 10.1

According to Keynes, at full employment, the excess demand for goods and services cannot be
met in real terms and, therefore, it is met by rise in the price of goods. Demand pull inflation
occurs only when there is an inflationary gap in the economy. The aggregate demand line AD
intersects the 45º line at point E, which is to the right of the full employment line. Thus, at full
employment there is excess demand which pulls up prices (Figure 10.2).
Figure 10.2

Samuelson says that demand pull inflation simply means that increasing quantities of money
are competing for the limited supply of commodities and bid up their prices. As the rate of
employment falls and labour markets become light (i.e., markets become scarce) wages are bid
up and the inflationary process accelerates.

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