ALIA FARHAH TAHIR

Question
Prices always increase when output Y increases. Discuss whether
the statement is correct.

Answer
P always increase when Y increase is not always true. This can be proven by
using Keynesian theory of inflation (demand pull and cost push model of
inflation), classical theory and also by referring to stabilization policy (fiscal
and monetary policy).
Firstly, Keynesian theory of inflation consists of two models which are
demand-pull inflation and cost push inflation.
The demand-pull inflation is associated with increase in prices following
increase in aggregate demand or one of its components. The graph below
illustrates the aggregate supply curve consisting of three ranges:
Keynesian (horizontal section)
Intermediate (upward sloping section), and
Classical/monetarist (vertical section).
Keynesian section represents all levels of output below full employment
output point. Therefore, Y* > YF. The gap between the two is called
inflationary gap. In this section, the price doesnt change, only the output is
increasing. Hence here, Y increases but P remain constant.
In intermediate range, both prices and output are increasing. This is due to
the fact that when approaching full employment output point, the prices of
inputs start to rise and this is passed through to the prices of output. In other
words, the only way for producer to increase output is to increase the prices,
since no more unused factors of production are available at full employment
output level. This happens gradually, rather than drastically. Therefore, here
P increases when Y increases.
Thirdly, in the classical range of the AS curve, when full employment output
level YF is reached, physical units of production cannot rise, but prices of
these units can. The whole excess demand that corresponds to Y* > YF leads
to price increase. Because this happens to the right of YF the gap between Y*
and YF is called inflationary gap. So here, P increases but Y remains
constant.

ALIA FARHAH TAHIR

[You can also illustrate this using AD-AS curve. See left graph below]

The cost push inflation is caused by an increase in cost. It is also one

possible cause of stagflationa situation in which output is falling at the
same time that prices are rising. An example of stagflation is a recession in
1970s that were caused by increase in oil price (cost increase). The recession
caused output to be reduced. Based on the graph below we can see that an
increase in oil price shifts the SRAS curve to the left. Thus, short run
equilibrium move to point B with lower output and higher price. Therefore, in
this case P increases but Y decreases which doesnt support the
statement.

ALIA FARHAH TAHIR

Secondly, Monetarist school asserts that inflation is always a monetary

phenomenon. This is because monetarists believe economy operates on
vertical section of AS curve, i.e. economy is always on or close to potential
output. Attempts to stimulate economy will not change real output, but will
instead lead to higher prices.
The building block for monetarist theory is Quantity Theory of Money
equation. It says that, MV = PYf. Here, M is the money supply, V is velocity of
money, P is level of price and Yf is the full employment output. Monetarist
argue that Yf is fixed in the short run and V is stable. This means change in
money supply will result in inflation. As we can see from the graph below, P
increases from P1 to P2 because of an increase in money supply but Y remains
constant. Hence, in this case P increase but Y remains constant.

ALIA FARHAH TAHIR

The reference to stabilization policy may help explaining the relationship

between prices and output in the business cycle and AD/AS framework.
Lastly, stabilization policy describes both monetary and fiscal policy, the
goals of which to smooth out fluctuations in output and employment and to
keep prices as stable as possible. The goal is not to prevent the overall price
level from rising at all but instead to achieve an inflation rate that is good.
The IS-LM model is a useful tool to analyze the impact of monetary policy and fiscal
policy on the level of output.
Fiscal policy is the control of government expenditure and revenue (taxation). Fiscal
policy only applies on the IS curve. The IS curve will shift to the right when G 0, T0,
X0, M0, C0 and I0.

Monetary policy is a tool to control money supply. It applies on the LM curve.

The LM curve will shift to right when Ms, M0d and when there is technological
change.

Consequently, in AD-AS model, fiscal policy and monetary policy will only
affect AD curve but not SAS curve. For example, based on the graph below
we can see that the starting equilibrium is at P0. If there is a shock supply
(cost increase), supply will decrease therefore SAS curve will shift to the left.
Then, when stabilization policy takes place (monetary and fiscal policy) AD
curve will shift to the right. This will make new equilibrium where the output
is the same as the origin but price is higher now. Overall, P increases but Y
remains constant.

ALIA FARHAH TAHIR

We thereby conclude that the statement that prices always increase in

unison with aggregate output is incorrect. There are several factors which
affect inflation (the principal being the phase of business cycle and the
current position of the economy), as well as a number of theories explaining
inflation.