Macroeconomics: Demand-Pull and Cost-Push Inflation, Keynesian-Monetarist Controversy, Impact on AD-AS, Banks and Money Creation

This article explains the concepts of demand-pull and cost-push inflation, Keynesian-Monetarist controversy, impact on AD-AS, and banks and money creation in macroeconomics. It also discusses the causes of inflation and the impact of various factors on the economy. The article is relevant for students studying macroeconomics and related courses.

Running head: MACROECONOMICS
Business Economics
Name of the Student:
Name of the University:
Author note:

Price AS
AD1
AD2
P1
P2
Y2Y1
1
GDP
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Answer 3(a)
Demand-pull inflation represents the inflation that occurs when the aggregate demand in the
economy rises causing the actual GDP to go higher than the potential GDP (Mankiw 2014). Price
increases due to the excess demand in the economy and creates demand-pull inflation. This is
most likely to happen when the resources are fully employed and the aggregate supply curve is
inelastic. This results in the increase of both the price and GDP.
Figure 1: Demand-pull inflation
(Source: Author)
Cost-push inflation arises when the producers increase the price of products to offset the
increasing cost of production. The production cost increases due to higher prices of the raw
materials, higher price of labor or increasing taxes. The aggregate supply in the economy
decreases due to cost-push inflation, that is, price increases but GDP decreases.

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Price AS1
AD
AS2
P1
P2
Y2 Y11 GDP
Figure 2: Cost-push inflation
(Source: Author)
Answer 3(b)
Causes of demand-pull inflation
1. Rise in the money supply more than the rise in the production or output, thereby
increasing the aggregate demand.
2. Increase in macro-economic factors like increase in the government expenditure or
decrease in tax, increase in the investment or decrease in savings and increase in net
exports.
Causes of cost-push inflation
1. Increase in the wages, resulting in the increase in the cost of labor

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2. Increase in the price of raw materials resulting in the increase in the production cost of
goods and services.
Answer 4(a)
According to the Keynesians, when the central bank of an economy lowers the rates of
interest by raising the money supply, it influences the people to increase their investment
(Heijdra 2017). This leads to a rise in the aggregate demand causing demand pull inflation.
Keynesian economists consider the velocity of money to be unstable and volatile both in the
short and long run. During the full employment, rise in the money supply can change the
aggregate demand in the economy. However, during recession, this would not have much effect.
The rise in the money supply would lower the interest rate, but the borrowers might increase
their purchase due to pessimistic expectations (Evans and Honkapohja 2012). This increases the
level of investment resulting in the increase in the aggregate demand. Due to this reason, the
price level increases along with the GDP.
On the other hand, according to the monetarists, when the central bank raises the money
supply, higher liquidity in the economy encourages people to spend more (Mankiw 2014). This
causes demand pull inflation. The monetarists consider the velocity of money to be stable.
Hence, they believe that a change in money supply could change the aggregate demand. Increase
in the supply of money thus raises aggregate demand and leads to inflation (Johnson 2017).

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Answer 4(b)
The shape of the aggregate supply curve is important to the Keynesian-Monetarist
controversy because, if it is considered that the aggregate supply (AS) curve is horizontal and
economy is at a lower level than the full employment, increase in the aggregate demand (AD)
will result in increased GDP (Gandolfo 2013). According to the Keynesian economists, the AS
curve is horizontal in the short run. Hence, the policies can have an effect on the GDP and
employment, especially in the long run.
On the contrary, the monetarists believe that the AS curve is vertical and hence, they do
not think that the discretionary stabilization policies have any effectiveness (Johnson 2017).
Answer 5(a)
A significant destruction in an economy’s capital stock refers to a decrease in the capital
stock and this leads to a shift in the aggregate supply (AS) curve to the left. If no change in the
aggregate demand (AD) is assumed, then the new equilibrium would be reached at a point,
where the full employment GDP is lower and the price level increases too.

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Price AS1
AD
AS2
P1
P2
Y2 Y11 GDP
Figure 3: Decrease in capital stock and its impact on AD-AS
(Source: Author)
Answer 5(b)
Increase in the personal income tax leads to a fall in the disposable income of the people,
thereby lowering the level of demand. This causes the aggregate demand (AD) curve to shift to
the left. If no initial shift in the AS is assumed, then the new equilibrium would be reached at a
point where a full employment level of real GDP is lower. The price level would be lower too.

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Price AS
AD2
AD1
P2
P1
Y1Y21 GDP
Figure 4: Impact of rise in personal taxes on AD-AS
(Source: Author)
Answer 5(c)
Increase in export signifies rise in GDP, which in turn signifies a rise in the aggregate
demand. This causes a rightward shift of the AD curve, causing demand pull inflation. If there is
no initial shift in the AS curve, the new equilibrium would be at a point where the full
employment GDP is higher along with the price.

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Price AS
AD1
AD2
P1
P2
Y2Y11 GDP
Figure 5: Impact of increase in exports on AD-AS
(Source: Author)
Answer 5(d)
An improvement in the marketing and selling skills of firm managers leads to the
increase in demand for the firm’s product or service and hence, there will be an increase in
output, thereby increasing the GDP. This leads to a rise in aggregate supply in the economy,
causing a rightward shift in the AS curve. Price will increase or decrease depending on the
magnitude of the shift in the AD or AS.

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Price AS2
AD1
AD2
P1
P2
Y2 GDP
AS1
Figure 6: Impact of improvement in the marketing and selling skills of firm managers on
AD-AS
(Source: Author)
Answer 6(a)
‘Banks do not create money because this is the Central bank’s (Reserve Bank of Australia)
responsibility’: Disagree
Although the central bank has the responsibility of creation of money through influencing the
money supply in the economy; the commercial banks are also able to create money by lending
money to the customers in the exchange of new bank deposits. The deposits are taken in the form
of money and hence, that represents creation of money. The money multiplier determines the
magnitude to which the banks can convert the new deposits into money supply in the economy.
Y11

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Answer 6(b)
Deposition of cheque from one bank to the other would not affect the amount of money supply in
the economy as that is only transfer of money from one bank to other.
Answer 6(c)
The maximum money that a bank lends equals to the excess reserves. Reserve ratio refers to the
percentage of money that the bank must keep as a deposit, which cannot be lent (Wray 2015).
Westpac must keep 10% of $1000, that is, $100 as reserve and can lend $900 (i.e. $1000 - $100)
from the deposit.

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References
Evans, G.W. and Honkapohja, S., 2012. Learning and expectations in macroeconomics.
Princeton University Press.
Gandolfo, G., 2013. International Economics II: International Monetary Theory and Open-
Economy Macroeconomics. Springer Science & Business Media.
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
Wray, L.R., 2015. Modern money theory: A primer on macroeconomics for sovereign monetary
systems. Springer.