The two main types of inflation are cost-push inflation and demand-pull inflation.
A general rule of thumb is that cost-push occurs when the unemployment rate is higher
than the natural rate, while demand-push inflation occurs when unemployment is lower
than the natural rate. In this case, policymakers believe that the natural rate is 5% when it
is 4%. Policymakers believe that the natural rate is higher than it is, so it is likely that
they will work to decrease it. Once the natural rate diminishes, policymakers will pursue
a stabilization policy to avoid possible demand-pull inflation. In order to avoid
demand-pull inflation, a contractionary policy that will lead to reductions in government
spending. These attempts to stabilize the economy could easily backfire and lead to an
economic downfall in an already existing recession which can be very harmful.
Aggregate demand will start to shift to the left as a result of these actions. Price levels
will also decrease, and the supply produced will be less and less. This is also going to
affect the unemployment rate negatively. Graphically we would see everything shift
either to the left or down since price levels, supply demanded, and quantity demanded
would decrease. It would be very tough to recuperate from such heavy economic
deflation.