Inflation

Aggregate Demand Factors

There is a strong link between demand side conditions and the possibility of inflation.  In very broad terms we can say that any increase in aggregate demand is likely to put pressure on productive capacity, and this could result in an increase in inflation.  On the other hand, when aggregate demand is falling it is likely to coincide with a fall in the rate of inflation as well.  It is important that you are able to apply the skills that you learned earlier in this course to explain why this happens.

When you are looking at aggregate demand and aggregate supply (as in the graph to the left), the vertical axis gives us an indication of the likely change in inflation.  Remember that when we were considering changes in microeconomic factors this axis was used to assess changes in price; as our focus shifts to the entire economy, movement of the equilibrium point can give us some indication about changes to the overall price level.  Generally speaking when the equilibrium point moves higher on the graph we would say that there has been “an increase in inflation”.  When it moves lower on the graph we can conclude that there has been a “decrease in inflation”.  Take careful note of this point – this does not mean that prices are falling, it simply means that the rate of increase in prices is not as fast as it had been in the past.

These changes could occur as a result of many different demand side factors.  For example:

Consumption Spending: Consumers might choose to spend more money if they are feeling more confident, or if they start earning more money.  Average wages do increase over time, and it is also possible for disposable incomes to increase based on a fall in income tax rates.  Any of these situations could lead to an increase in consumption spending, and therefore an increase in aggregate demand.  This, in turn, could result in a higher rate of inflation.

Investment Spending: It is also possible for an increase in investment spending to fuel an increase in the rate of inflation.  For example, when businesses feel more confident they will spend more money, and this can also happen when the Reserve Bank chooses to lower the cash rate.  Should the government act to reduce the company tax rate, this could also result in an increase in aggregate demand via the investment spending component.

Government Spending: It is very unlikely that government spending will add to inflationary pressures, although it has certainly happened in the past.  The government is more likely to run a budget deficit (ie spend more money than they take in taxes) when the economy is performing badly.  At this time it is likely that inflation would be relatively low anyway.

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