Suppose we observe an economy experience an economic expansion and high inflation. This means the expansion is attributed to
a. a reduction in aggregate supply.
b. a reduction in aggregate demand.
c. growth in aggregate demand.
d. growth in aggregate supply.
The correct answer and explanation is:
The correct answer is: c. growth in aggregate demand.
Explanation:
When an economy experiences an economic expansion along with high inflation, it generally means that the total demand for goods and services in the economy has increased significantly. This situation is typically explained by growth in aggregate demand (AD).
Aggregate demand is the total quantity of goods and services demanded across all levels of an economy at a given overall price level and during a specific period. It includes consumption, investment, government spending, and net exports.
- Economic expansion means the economy’s output (real GDP) is increasing. More goods and services are being produced and consumed.
- High inflation means that the general price level is rising quickly.
These two phenomena together suggest that demand is outpacing supply, pushing prices up.
Why not other options?
- a. a reduction in aggregate supply: A reduction (shift left) in aggregate supply (AS) means the economy’s capacity to produce goods and services is decreasing. This can cause inflation (cost-push inflation) but usually leads to a contraction in output or stagflation rather than expansion. So, economic expansion plus inflation does not fit this scenario well.
- b. a reduction in aggregate demand: A fall in aggregate demand leads to lower output and downward pressure on prices (deflation or lower inflation). This contradicts the given situation of expansion and high inflation.
- d. growth in aggregate supply: An increase in aggregate supply shifts the supply curve rightward, meaning more goods and services are produced at every price level. This generally leads to economic expansion with stable or even lower inflation (or deflation), since supply growth tends to moderate prices. So, it does not explain high inflation during expansion.
Summary:
- Growth in aggregate demand shifts the AD curve to the right.
- This increases output (economic expansion).
- Simultaneously, it increases the price level (high inflation) because demand exceeds supply capacity in the short run.
Thus, economic expansion accompanied by high inflation is best explained by growth in aggregate demand.