But a reduction in investment spending reduces aggregate demand. The AD curve shifts to the left, reducing the incipient pressure on prices that exists at Y 0 in the following aggregate-output diagram. Note that the level of output Y 0 exceeds the natural output level. By definition, the natural output level is the maximum output level consistent with price stability. When Y rises above Y n , demand pressure in factor markets begins to raise the cost of production for firms throughout the economy.
Firms respond to higher costs by increasing prices.
But this process takes time. Aggregate demand must work its way down through the retail, wholesale, and manufacturing sectors before it affects the factor markets. Even then, factor prices don't begin to rise immediately. At least that's the case in the most important factor market - the labor market. Since inflation is so costly to stop once it's underway, the Fed takes great pains to avoid letting inflation become established in the economy.