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A-Level Economics · AD shift right (with multiplier) diagram question

The cost of the stimulus: why does demand-pull inflation appear as output reaches Y₃?

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The answer

As spare capacity runs out, firms compete for fixed factors — bidding up wages, materials and rents. Spare capacity is exhausted, so extra demand presses on fixed factors of production — wages, raw materials and rents get bid up and feed through to prices. As spare capacity is exhausted, firms compete for the same fixed factors of production and bid up wages, raw materials and rents. That cost pressure feeds through to prices: the price level climbs P₁ → P₂ → P₃. Notice the trade-off — every bit of extra growth here is bought with a bit more inflation.

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