Ch. 12: Inflation• Types of inflation

– Demand-pull inflation– Cost-push inflation

• Effects of inflation

• SR and LR long-run relationships between – inflation & unemployment– inflation & interest rates

Inflation and the Price Level• Inflation

– a process in which the price level is rising and money is losing value.

– an ongoing process, not a one-time jump in the price level.

Inflation and the Price Level

– The inflation rate between 2 years:• [(P1/P0)-1] 100

– Average annual inflation rate over T years• [(PT/P0)1/T - 1]

– Two types of inflation• Demand-pull• Cost-push

Demand Pull Inflation

Caused by repeated increases in AD.

AD increases

• Upward pressure on real wages shifts AS leftward

AD increases again.

• Cycle starts again.

LAS

SAS

AD

Demand Pull Inflation

A Demand-Pull Inflation Process

Aggregate demand keeps increasing and the process repeats indefinitely.

Demand Pull Inflation

Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

Demand-pull inflation occurred in the United States during the late 1960s and early 1970s.

Cost-Push Inflation

– Cost-push inflation• results from an initial increase in costs.

– Main sources of increased costs• An increase in the money wage rate• An increase in the money price of raw materials,

such as oil or food.

Initial Effect of a Decrease in Aggregate Supply

A rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward.

Cost-Push Inflation

Real GDP decreases and the price level rises—a combination called stagflation.

The rising price level is the start of the cost-push inflation.

Cost-Push Inflation

Cost-Push Inflation

• Aggregate Demand Response– The initial increase in costs creates a one-

time rise in the price level, not ongoing inflation.

– To create continued inflation, aggregate demand must increase.

The Fed may increase AD to restore full employment.

The increase in aggregate demand shifts the AD curve rightward.

Real GDP increases and the price level rises again.

If oil prices rise again, the cycle repeats.

Cost-push inflation occurred in the United States during 1974–1978.

Cost-Push Inflation

Effects of Inflation

• Forecasting Inflation– To minimize the costs of incorrectly

anticipating inflation, people form expectations about the inflation rate.

– A rational expectation • an expectation based on all relevant information • the most accurate forecast possible• Not necessarily correct

•AD increases• If the resulting inflation is anticipated, nominal wages rise to offset it•AS shifts left•Effect on

•Real wages?•Unemployment?•Real GDP?

Anticipated Inflation

The Costs of Anticipated Inflation

While economy remains at full employment and potential GDP, there are costs to anticipated inflation.

1. Transactions costs

•Shoe leather costs, •“flight from money”• menu costs

2. Tax effects

• bracket creep• indexing

3. Increased uncertainty

•Contract length

Unanticipated Inflation• If AD increases by more than expected,

– inflation is higher than expected.– Money wages do not rise enough, – SAS curve does not shift leftward enough to keep the

economy at full employment.– Real GDP exceeds potential GDP.– Unemployment falls below natural rate.– Wages eventually rise, which leads to a decrease in

the SAS and a return to potential GDP.• If AD increases by less than expected, above is

reversed.

Effects of Inflation

• Effects of Unanticipated Inflation– Redistributes income

• Borrowers win, lenders lose• Employers win, employees lose

– Departure from full employment• Phillips curve

Effects of Inflation

– If AD shifts more than anticipated:

– Upward shift in SAS is less than upward shift in AD

– Inflation > expected

– Real wage falls– Unemployment

falls

AD0

AD1

AS0

AS1

LAS

Effects of Inflation

– If AD shifts less than anticipated:

– Upward shift in SAS is greater than upward shift in AD

– Inflation < expected– Real wage rises– Unemployment

risesAD0

AD1

AS0

AS1

LAS

The Phillips Curve

Shows the relationship between the inflation rate and the unemployment rate.

The SR Phillips curve• shows tradeoff between the inflation rate and unemployment rate holding constant

– The expected inflation rate– The natural unemployment rate

The LR Phillips curve•Shows tradeoff between the inflation rate and unemployment rate when inflation equals expected inflation.

The Phillips Curve

A Short Run Phillips Curve (SRPC)

downward-sloping

If the inflation rate rises, real wages drop causing unemployment to fall.

If the inflation rate falls, real wages rise causing unemployment to rise.

The Long-Run Phillips Curve

The LRPC

shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.

is vertical at the natural rate of unemployment.

changes in inflation have no effect on unemployment in the LR because it is perfectly anticipated.

The Long-Run Phillips Curve

Unempl. rate

Inflation rateLRPC

SRPC

Unat

The Phillips Curves

If inflation equals the expected rate, unemployment equals the natural rate.

SRPC=LRPC at the expected rate of inflation.

A lower expected inflation rate shifts the SRPC downward by an amount equal to the fall in the expected inflation rate.

The Phillips Curves

Changes in the Natural Unempl. RateA change in the natural unemployment rate shifts both the long-run and short-run Phillips curves.

Potential causes?

The U.S. Phillips Curve

The U.S. Phillips Curve

Interest Rates and Inflation

Interest rates and inflation rates are correlated, although they differ around the world.

Interest Rates and Inflation

A positive correlation between the inflation rate and the nominal interest rate across countries.

Interest Rates and Inflation

• How Interest Rates are Determined– Nominal interest rate = real interest rate +

inflation rate. – The real interest rate is determined by

investment demand and saving supply in the global capital market.

– The nominal interest rate changes if• Real interest rate rises• Expected inflation rate rises.

Interest Rates and Inflation

• How would financial markets adjust to expectation of – rising inflation?

• Effect on yield curve

– more uncertain inflation?• Yield curve• ARMs• TIPS