Activity 5(k)

Activity 5k: Cost vs demand inflation

  1. Demand inflation occurs when the growth in AD exceeds the capacity of the economy to supply sufficient goods and services (i.e. maximum aggregate supply/productive capacity) to meet that demand.  As shown in the diagram to the left, demand inflation increasingly occurs when AD increases beyond AD, where capacity constraints become more and evident as AD approaches the red line (productive capacity).  In contrast, cost inflation occurs when there is an increase in the costs of production across the economy (e.g. growth in the costs of labour) which causes producers to raise prices (in order to protect profit margins).  The is evidenced by the AS curve in the second diagram shifting to the left and causing higher equilibrium prices in the economy. 
  2. This is because when AD increases from AD2 to AD3 it exerts more pressure on productive resources given that the economy is already producing at close to its productive capacity. Faced by shortages/tighteness in product and factor markets that make it difficult for firms to meet the demand for their goods and services, firms raise prices and inflation is the result.  In contrast, when AD increases from low levels (e.g. AD0 to AD1) there is lots of spare capacity in the economy meaning that it will be easy to for firms to increase output in response to higher demand.  As a consequence, there will be minimal impact on prices.
  3. As AD increases beyond AD3 the outcome will be much higher prices accompanied by smaller and smaller increases in output (real GDP). Once AD increases beyond *1, then inflation is the only variable to increase given that the economy has reached its productive capacity and is unable to expand output beyond *1.  The common solution used by Australian authorities when faced by demand inflation is to implement contractionary/restrictive budgetary and monetary policies.  This will involve the government reducing the size of its budget deficit (or increase the size of its budget surplus) and/or the RBA tightening monetary policy by raising interest rates.  Both of these policy actions are designed to restrain the growth in AD and reduce the demand inflationary pressures.  [Alternatively, the government could implement policies that are designed to boost the nation’s productive capacity over the medium to longer term, such as aggregate supply policies that ultimately boost productivity/efficiency and raise productive potential.]
  4. The decline in consumer sentiment over 2016-17 is a factor that is reducing consumption demand as consumers become more cautious about the state of the economy and/or the state of their finances more generally. In addition, the higher value of the AUD over 2017 is having a negative impact on net export demand (X-M) because our goods and services become less price attractive to foreigners (and imports become more attractive to local businesses and consumers). Both of these factors reduce AD in the economy and therefore decrease demand inflationary pressures.