An economy is said to operate at the stage of full employment of resources. When the employment condition is achieved, no productive resources are left idle to be utilized for higher production of output. Thus any increase in aggregate demand can no way increase the aggregate supply. Production of output remains unresponsive of increase in price.
Thus at full employment condition the aggregate demand is equal to aggregate supply of output. If aggregate demand exceeds aggregate supply at full employment equilibrium, it will automatically give boost to the price level. The equilibrium at full employment level of national income is achieved when aggregate investment is large enough to offset the saving, gap corresponding to the employment level of income the aggregate demand for goods is not always equal to the full employment level of aggregate supply.
Sometimes the aggregate demand for goods and services of the economy may be more than aggregate supply at full employment level of resources due to cereal battlement in the economy. This creates the problem of excess demand. Thus when aggregate demand exceeds aggregate supp at the current prices, the general price level will rise. Thus inflation is the result of excess demand and such inflation is called demand pull inflation. When there is full employment of resources the economy can not produce more.
If the aggregate demand exceeds aggregate supply available from full utilization of the productive capacity of the economy, the prices will rise to equate aggregate demand with aggregate supply.
Excess demand inflation occurs when aggregate demand for goods and services is greater than the available supply of these goods and services at the existing prices level. Excess demand means aggregate real demand for output in excess of maximum feasible, or potential or full employment output at the going price level. Thus
its useful to explain the concept of inflationary gap in order to know the main cause of the rice is general price level. The equilibrium of an economy is established at the level of full employment when aggregate demand is equal to the level of income corresponding to full employment level of resources. This happens when the amount of Investment is equal to the saving gap corresponding to full employment level of income.
In the above diagram OY is national income at the level of full employment. Equilibrium at national income OY can be established only when aggregate demand or total expenditure (C+l+G) is equal to ‘YR’ (YR-OY). When all factors like labour are fully employed, there is no possibility of further rise in production or national income. Thus when, aggregate demand is greater YR, the equilibrium will not be established at OY.
The aggregate demand YQ is greater than aggregate supply of output YR which is being produced at the full employment level OY. Thus with the level of aggregate demand (C+l+G) equal to YQ, equilibrium would not established at OY which corresponds to full employment.
The actual aggregate demand being greater than yr by the amount QR, the level of national income will be greater than oy. Since oy is a full employment level-of income, real production cannot increase beyond that but there will be rise in prices which will raise the money value of oy amount of production.
The amount by which the actual aggregate demand exceeds the level of aggregate production corresponding to full employment is known as inflationary gap because this excess aggregate demand causes inflation or rise in the general price level in the economy.
The excess of aggregate demand is equal to QR. With aggregate demand YQ aggregate demand curve C+l+G interest 45° line at S and equilibrium level of national income would be Oy It should be carefully understood that there is no difference between. OY and OY, in terms of real production only as a result at rise, in prices, the level of national income has increased from OY to OY, in terms of money.
Beyond OY corresponding to the equilibrium point R aggregate demand cannot raise employment of resources including labour. Inflationary gap represents excess demand in relation to aggregate production or supply of output which brings about demand-pull inflation.
Keynes in his pamphlet entitled how to pay for the war, 1940 explained inflation in terms of inflationary gap. According to him inflationary gap exists when, at full employment income level, aggregate demand exceeds aggregate supply. Thus means that due to increase in investment and Govt, expenditure, the money income increases, but production does not increase, because of the limitations of productive capacity. As a result an inflationary gap comes to exist, causing the prices to rise.