Figure 1 Demand Pull Inflation

Price Level LRAS SRAS, p. p. p

Price Level LRAS SRAS,


Real GDP

Now suppose the central bank increases the money supply, which increases aggregate demand to ADr With no initial change in aggregate supply, output increases to GDP^ and the price level increases to Pv Prices rise, and real GDP is above potential (full-emplovmcnt) GDP,

With real GDP above its full-employment level, the increase in GDP is not sustainable. Unemployment falls below its natural rate, which puts upward pressure on real wages. Rising real wages result in a decrease in short-run aggregate supply (the curve shifts left from SRAS,) until real GDP reverts back to full-employment GDP. The boom turns into a bust as output falls back to GDPp and the price level increases further to Pv

In the absence of other changes, the economy would reach a new equilibrium price level at P^. But what would happen if the central bank tried to keep GDP above the full employment level with further increases in the money supply? The same results would occur repeatedly. Output could not remain above its potential in the long run, but the induced increase in aggregate demand and the resulting pressure on wages would keep the price level rising ever higher. Demand-pull inflation would persist until the central bank reduced the growth rate of the money supply and allowed the economy to return to full employment equilibrium at a level of real GDP equal to potential GDP.

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