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

Running head: MACROECONOMICS
Business Economics
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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).