To determine which sets of circumstances can confidently lead to inflation, we need to understand the concepts of aggregate supply and aggregate demand:
- Aggregate Supply (AS): Refers to the total supply of goods and services that firms in an economy plan on selling during a specific time period.
- Aggregate Demand (AD): Refers to the total demand for goods and services within an economy.
Inflation typically occurs when aggregate demand increases relative to aggregate supply. Here’s an analysis of each option:
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Aggregate supply and aggregate demand both increase: This situation will not necessarily lead to inflation as both supply and demand are rising. The effect on prices is ambiguous and could lead to stable prices.
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Aggregate supply and aggregate demand both decrease: This scenario would likely lead to lower prices, or deflation, since both supply and demand are contracting.
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Aggregate supply decreases and aggregate demand increases: This scenario is likely to result in inflation. A decrease in aggregate supply (e.g., due to higher production costs) combined with an increase in aggregate demand (e.g., due to increased consumer spending) typically leads to higher prices.
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Aggregate supply increases and aggregate demand decreases: This situation would likely lead to lower prices, as more goods and services are being produced while demand is falling.
Based on this analysis, the only scenario in which we can confidently expect inflation is:
Aggregate supply decreases and aggregate demand increases.