Short-Run Aggregate Supply
There are several reasons why high levels of real GDP should be associated with higher inflation and a higher price level.
First when demand for products is stronger than anticipated firms elevate their prices higher than they had previously planned. When aggregate require is higher than potential output demand is strong in nearly every single industry. Almost all firms raise prices and hire more workers. Employment increase beyond its average proportion of the adult population and the unemployment rate falls below the ‘natural’ rate of unemployment--the rate at which the rate of inflation is steady. High demand offers workers extra bargaining power and they utilize it to bargain for higher wage levels than they had previously planned. Unions threaten to strike knowing that firms will have a hard time finding substitution workers. Individuals quit, knowing they are able to find better jobs elsewhere. Such a high-pressure economy generates salary that rise faster than anticipated. Rapid salary growth is passed along to consumers in higher prices and accelerating inflation. Therefore high real GDP generates higher inflation.
Second when aggregate demand is higher in compression to potential output individual economic sectors as well as industries in the economy quickly arrive at the limits of capacity: Bottlenecks emerge. Confronted with a bottleneck--a very important part, item or process where production can’t be increased quickly--potential purchasers bid up the price of the bottlenecked item. Since a car is ineffectual without brakes it is worth it for car manufacturers to pay whichever price for brake assemblies if they are in short supply. Such high price indicates to the market that the bottleneck industry should expand and triggers investment that in the end boosts productive capacity. However, developing bottlenecks lead to prices that rise faster than expected--thus to accelerating inflation.
To some degree the puzzle isn’t why high levels of real GDP (and low levels of unemployment) are associated with higher prices and inflation, however why the association is as weak as it is.
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