Use Shifts Of The AD And AS Curves To Explain Cost Push

117 Use Shifts Of The Ad And As Curves To Explain The Cost Push Infla

Use shifts of the aggregate demand (AD) and aggregate supply (AS) curves to explain the cost-push inflation of the 1970s. Additionally, address related questions about macroeconomic relationships, economic laws, and views.

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Cost-push inflation during the 1970s was primarily driven by supply shocks that caused the aggregate supply curve to shift leftward, resulting in higher price levels and stagnating or declining output. These shocks were largely due to rising costs of production, especially increases in oil prices following the oil embargo and other geopolitical tensions. The supply constraints led to a decrease in aggregate supply, depicting a leftward shift of the AS curve on the AD-AS model, which resulted in a higher equilibrium price level while output contracted or remained stagnant, illustrating stagflation.

In the context of the AD-AS model, the initial supply shock shifted the short-run aggregate supply (SRAS) curve leftward, reflecting increased production costs. This movement raised the general price level from P1 to P2 while decreasing real GDP from Y1 to Y2. If the AD curve remains unchanged at this point, the economy experiences rising inflation alongside falling output and employment, characteristic of cost-push inflation.

Furthermore, subsequent policy responses such as monetary tightening to combat inflation further shifted the AD curve leftward, exacerbating recessionary conditions. The combination of supply-side shocks and demand-side policies created a complex scenario where prices increased while economic growth slowed—a hallmark of the 1970s inflationary period. The persistent upward pressure on prices despite declining output exemplifies how supply shocks can cause sustained cost-push inflation, emphasizing the importance of supply-side policies to mitigate such inflationary episodes.

The mathematical relationship between real consumption and real GDP is described by the consumption function, typically expressed as C = a + MPC × Y, where C is total consumption, a is autonomous consumption, MPC is the marginal propensity to consume, and Y is real GDP. This function shows consumption increases with income, but not necessarily at a one-to-one rate, which helps explain aggregate demand dynamics.

Similarly, the relationship between real saving and real GDP is captured by the saving function, which can be expressed as S = -a + MPS × Y, where S is total savings, MPS is the marginal propensity to save, and Y is real GDP. This relationship illustrates how savings tend to increase as income rises.

As real GDP decreases, the average propensity to consume (APC)—which is calculated as C / Y—tends to increase. This is because consumers tend to spend a larger proportion of their income when their income diminishes, especially during economic downturns. Conversely, the average propensity to save (APS)—calculated as S / Y—decreases since saving becomes less feasible when income falls.

The relationship APC + APS = 1 is always true, because total income is either consumed or saved, meaning the sum of the average propensities must equal 1. This reflects the fundamental economic principle that all income must be allocated either toward consumption or saving.

Say's Law, rooted in classical economics, states that "supply creates its own demand." Essentially, it implies that producing goods and services generates the income necessary to purchase those goods, thereby ensuring that the economy naturally tends toward full employment and equilibrium in the long run.

The classical view posits that free markets lead to automatic self-correction, whereby wages and prices are flexible enough to bring the economy back to full employment without intervention. Prices adjust to clear markets, and supply-side factors primarily determine output, employment, and inflation in the long term.

A significant historical event that challenged classical economic thought was the Great Depression (1929), which revealed that economies could remain stuck in prolonged recessions. The severe unemployment and persistent under-utilization of resources led economists like Keynes to argue that active government intervention was necessary to stimulate demand and restore full employment.

Keynesian economics emphasizes that aggregate demand is the primary driver of economic output and employment. It argues that insufficient demand can lead to prolonged unemployment, and that government policies—through fiscal stimulus, such as increased public spending and tax cuts—are vital tools to stabilize the economy during downturns.

The investment demand curve for a business shows the relationship between the interest rate and the quantity of investment that firms are willing to undertake at each rate, holding other factors constant. In contrast, the investment schedule for an entire economy illustrates planned investment across different levels of aggregate income or GDP, influenced by broader factors such as interest rates, expectations, and technological innovations.

The equilibrium level of real GDP differs from the full-employment level in Keynesian models because aggregate demand may not always be sufficient to produce full employment output. Shortfalls in demand lead to unemployment and idle resources, requiring policy measures to boost spending and close the gap to potential output.

References

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