Inflation Dynamics: Demand Pull and Cost Push

Recessions and expansions influence inflation, characterized as a general increase in price levels.
There are two primary types of inflation:
- Demand Pull Inflation: Arises from an increase in aggregate demand.
- Cost Push Inflation: Arises from a decrease in aggregate supply.

Aggregate Demand and Supply: Start with long run equilibrium at price level $P$ and real GDP level $Y^*$ .
Increased Aggregate Demand: When aggregate demand increases from $AD$ to $AD_1$ , often due to increased government purchases:
- This shift leads the economy to a new short run equilibrium.
- Price Level Increase: The price level rises from $P$ to $P_1$ .
- Mechanism: Demand pull inflation occurs as higher aggregate demand causes consumers to compete for limited goods and services, thus driving prices up.

Long Run Full Employment Equilibrium: The discussion begins at price level $P$ and output level $Y^*$ .
Increase in Resource Costs: If resource costs increase, aggregate supply shifts to the left from $AS$ to $AS_1$ :
- As the economy moves to a new short run equilibrium, the price level rises from $P$ to $P_1$ .
- Result: The rise in the price level is attributed to the increased resource costs leading to higher prices for goods and services, which is characterized as cost push inflation.

Understanding Inflation: Distinguishing between demand pull inflation and cost push inflation can be complex but is crucial for:
- Determining the nature of rising prices in the economy.
- Selecting effective monetary and fiscal policy responses to address inflation.
Conclusion: Demand pull inflation and cost push inflation are essential concepts that describe how fluctuations in aggregate demand and aggregate supply impact inflationary trends in the economy. Understanding these mechanisms is vital for making informed economic decisions and policy formulations.