In macroeconomics, which statement best describes why inflation occurs, distinguishing between demand-pull and cost-push inflation?

• A. Inflation occurs only when real GDP falls, because falling output mechanically raises the price level.
• B. Inflation is caused only by increases in productivity, which raise wages and therefore prices.
• C. Inflation can occur when aggregate demand increases faster than the economy’s productive capacity (demand-pull) or when firms’ production costs rise and shift short-run aggregate supply left (cost-push).
• D. Inflation occurs only when taxes are cut, because lower taxes always reduce prices and create inflation at the same time.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of inflation as a general increase in the price level of goods and services in an economy over a period of time.
2. Step 2: Recognize that demand-pull inflation occurs when aggregate demand (total spending in the economy) increases faster than the economy's ability to produce goods and services, causing prices to rise.
3. Step 3: Understand that cost-push inflation happens when the costs of production for firms increase (such as wages or raw materials), which shifts the short-run aggregate supply curve to the left, leading to higher prices even if demand remains constant.
4. Step 4: Analyze why the other statements are incorrect: inflation does not only occur when real GDP falls, nor is it caused solely by increases in productivity or tax cuts.
5. Step 5: Conclude that the best description of why inflation occurs is the combination of demand-pull and cost-push factors, where either rising demand or rising production costs can lead to higher overall price levels.