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INFLATION
MR JOSHEEL KUMARS11066159
INFLATION: DEMAND-PULL AND COST-PUSH
Inflation is the process in which the price level is rising and money is losing value.
Inflation is not the increase in the price of one item.
Inflation is the increase in the price of all items by similar percentages.
A one-time jump in the price level is not inflation.
Inflation is an ongoing process
2002 2003 2004 2005 2006 2007
Pri
ce le
vel (
2003
/04
= 1
00)
90
100
110
120
130
140
150
160
Inflation, ongoingprocess of rising price level
A one-time risein the price level
Year
INFLATION VERSUS A ONE-TIMERISE IN THE PRICE LEVEL
Figure 29.1
INFLATION: DEMAND-PULL AND COST-PUSH
To calculate the inflation rate, the difference in the price level of the two years is divided by the first year’s price level.
INFLATION: DEMAND-PULL AND COST-PUSH
For example if this year’s price level is 126 and last year’s was 120, then inflation is:
100120
120 – 126 RateInflation
= 5 percent per year.
INFLATION: DEMAND-PULL AND COST-PUSH
Inflation can result from either an aggregate demand shock or an aggregate supply shock
These two sources of impulses are called
1. Demand pull inflation
2. Cost push inflation
INFLATION: DEMAND-PULL AND COST-PUSH
Demand-Pull Inflation
Demand-pull inflation is inflation that results from an initial increase in aggregate demand.
This can result from an: Increase in the quantity of money Increase in government expenditures Increase in exports
INFLATION: DEMAND-PULL AND COST-PUSH
Demand-Pull Inflation
Initial Effect of an Increase in Aggregate Demand If an event leads to an increase in
aggregate demand when the real GDP equals full employment real GDP, both GDP and the price level will increase initially.
AD1
Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
95
105
125
800 900 950 1,050850 1,000
LAS
108
SAS0
AD0
Increase in AD raises price leveland increasesreal GDP...
0
A DEMAND-PULL RISE IN THE PRICE LEVEL (A) INITIAL EFFECT
Figure 29.2(a)
SAS1
AD1
95
105
125LAS
108
SAS0
AD0
116
…wages rise, andSAS shifts leftward.Price level risesfurther, and real GDP declines
0
A DEMAND-PULL RISE IN THE PRICE LEVEL (B) WAGES ADJUST
800 900 950 1,050850 1,000Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
Figure 29.2(b)
INFLATION: DEMAND-PULL AND COST-PUSH
Demand-Pull Inflation Money Wage Rate Response
However, a shortage of labour exists and wages begin to rise.
Short-run aggregate supply begins to decrease and the SAS curve shifts leftward.
The price level rises, and real GDP begins to decrease toward full employment real GDP.
AD2
SAS1
AD1
105
128
LAS
108
SAS0
AD0
116110
SAS2
Repeated increasesin AD create a price-wage spiral
0
A DEMAND-PULL INFLATION SPIRAL
Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
800 900 950 1,050850 1,000
Figure 29.3
INFLATION: DEMAND-PULL AND COST-PUSH
Demand-Pull Inflation
A Demand-Pull Inflation Process For inflation to persist, aggregate demand
must increase repeatedly, and.. …the quantity of money must persistently
increase.
INFLATION: DEMAND-PULL AND COST-PUSH
Cost-Push Inflation
Cost-push inflation is inflation that results from an initial increase in costs.
This can result from an: Increase in money wage rates Increase in the money prices of raw
materials
INFLATION: DEMAND-PULL AND COST-PUSH
Initial Effect of a Decrease in Aggregate Supply Assume there is a sharp increase in the
prices of key raw materials like oil Cost of production rises leading to firms to
decrease the quantity of labour employed and to cut down production
The short run aggregate supply curve shifts leftwards leading to a fall in output and a rise in prices, resulting in a situation called stagflation
95
105
125
LAS
112SAS0
AD0
115
SAS1
Factor price riseshifts SAS leftwardand causes stagflation
0
A COST-PUSH RISE IN THE PRICE LEVEL
800 900 950 1,050850 1,000Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
Figure 29.4
INFLATION: DEMAND-PULL AND COST-PUSH
Cost-Push Inflation
Aggregate Demand Response When real GDP falls, unemployment rises
above the full employment rate. The RBA may respond by increasing the
money supply. Aggregate demand increases. Full employment has been restored, but
prices have increased further.
105
125
LAS
112SAS0
AD0
116
SAS1
The Reserve Bank increases AD to restore full-employment and the price level rises again
0
AD1
AGGREGATE DEMAND RESPONSE TO COST PUSH
Real GDP (billions of 2003/04 dollars)
Pric
e le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
800 900 950 1,050850 1,000
Figure 29.5
INFLATION: DEMAND-PULL AND COST-PUSH
Cost-Push Inflation
A Cost-Push Inflation Process As a result of this second increase in the
cost of production, the oil companies raise the price of oil a second time.
The short-run aggregate supply curve shifts leftward and stagflation begins again.
The process repeats itself.
105
110
128
LAS
112SAS0
AD0
116
SAS1
Oil producers and the Reserve Bank feed the cost-price inflation spiral
0
AD0
SAS2
AD2
124
A COST-PUSH INFLATION SPIRALPr
ice
leve
l(G
DP
defl
ator
, 200
3/04
= 1
00)
Real GDP (billions of 2003/04 dollars)800 900 950 1,050850 1,000
Figure 29.6
THE QUANTITY THEORY OF MONEY
The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
This theory is based on the concept of the velocity of circulation and on the equation of exchange.
GDP = PY
GDP equals the price level (P) times real GDP (Y), or:
THE QUANTITY THEORY OF MONEY
The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.
THE QUANTITY THEORY OF MONEY
Call the quantity of money M. The velocity of circulation V is determined by:
The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP:
V = PY/M
MV = PY
THE QUANTITY THEORY OF MONEY
By virtue of the definition of the velocity of circulation, the equation of exchange is always true.
The equation of exchange becomes the quantity theory of money by making two assumptions: 1. The velocity of circulation 2. Potential GDP
This can be shown by using the equation of exchange to solve for the price level. Divide both sides by Y:
P = (V/Y) x M
THE QUANTITY THEORY OF MONEY
Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.
D P = (V/Y) x D M
THE QUANTITY THEORY OF MONEY
In the long run, real GDP equals potential GDP. If potential GDP and velocity are not
influenced by the quantity of money, then the relationship between the change in the price level and the change in the quantity of money is:
D P/P x 100 = D M/M x 100
The percentage increase in the price level and the quantity of money are equal.
THE QUANTITY THEORY OF MONEY
Divide this equation by P = (V/Y)M and multiply by 100 to get
THE EFFECTS OF INFLATION
Unanticipated Inflation in the Labour Market Two consequences of unanticipated
inflation in the labour market are:
Redistribution of income Departure from full employment
THE EFFECTS OF INFLATION
Unanticipated Inflation and the Labour Market
Redistribution of Income If inflation increases unexpectedly, wages
have not been set high enough. Business profits will be higher than
expected, and real income will be less than expected.
Businesses gain and workers lose.
THE EFFECTS OF INFLATION
Unanticipated Inflation and the Labour Market
Redistribution of Income If inflation is below what had been
anticipated, workers gain and employers lose.
Therefore, it is beneficial for both groups to correctly anticipate the rate of inflation.
THE EFFECTS OF INFLATION
Unanticipated Inflation and the Labour Market
Departure from Full Employment Underestimating the inflation rate leads
to: Less real incomes for workers: Employers cannot find adequate labour Employees begin to quit Firms incur labour turnover costs
Production is below what it would have been had the inflation rate been correctly anticipated.
EFFECTS OF INFLATION
Departure from Full Employment Overestimating the inflation rate leads
to: More real incomes for workers: Employers lay off workers Unemployment rate increases
Production is below what it would have been had the inflation rate been correctly anticipated.
THE EFFECTS OF INFLATION
Unanticipated Inflation in the Market for Financial Market Two consequences of unanticipated
inflation in the capital market are:
1) Redistribution of income
2) Too much or too little lending and borrowing
THE EFFECTS OF INFLATION
Unanticipated Inflation in the Market for Financial Market Redistribution of Income
Unanticipated inflation leads to interest rates not being set high enough to compensate lenders.
Borrowers gain, lenders lose.
THE EFFECTS OF INFLATION
Redistribution of Income If inflation is below what had been
anticipated, interest rates will be set too high.
Lenders gain, borrowers lose.
THE EFFECTS OF INFLATION
Too Much or Too Little Lending and Borrowing If inflation is higher than expected:
Borrowers wish they had borrowed more Lenders wish they had lent less
THE EFFECTS OF INFLATION
Forecasting Inflation Inflation is difficult to forecast correctly. People devote considerable resources
in the attempt to improve the forecasts. Rational expectation is the most
accurate forecast possible and is based on all relevant information.
THE EFFECTS OF INFLATION
Anticipated Inflation Money wages are assumed to be sticky
while an economy is experiencing demand-pull and cost-push inflation.
Correctly anticipating increases in the price level, people will adjust their money wage rates to compensate.
SAS2
SAS1
110
LAS
SAS0
AD0
121
133
AD1
AD2
Anticipated increasesin AD bring inflationbut no change in real GDP
0
ANTICIPATED INFLATION
800 900 950 1,050850 1,000Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)Figure 29.9
THE EFFECTS OF INFLATION
Unanticipated Inflation If aggregate demand increases by
more than expected, wage increases likely will lead to a demand-pull inflation spiral.
If aggregated demand increases by less than expected, wage increases may lead to a cost-push inflation spiral.
THE EFFECTS OF INFLATION
The Costs of Anticipated Inflation High rates of anticipated inflation can
be costly. Potential GDP declines for three
reasons: Transactions costs Tax effects Increased uncertainty
THE EFFECTS OF INFLATION
Transactions Costs The velocity of circulation of money
increases. People spend time in the attempt to
avoid incurring losses from the decline in the value of money.
People seek alternatives to money — barter.
THE EFFECTS OF INFLATION
Tax Effects Nominal interest rates increase. Taxes are based on dollar returns. Returns on investments result in higher
taxes. The effective tax rate rises, and the
after tax real interest rate declines.
THE EFFECTS OF INFLATION
Increased Uncertainty High inflation rates result in uncertainty
about the long-term inflation rate. Investment falls Growth falls
UNEMPLOYMENT AND INFLATION:THE PHILLIPS CURVE
The Phillips curve shows the relationship between inflation and unemployment.
There are two time frames for Phillips curves: The short-run Phillips curve The long-run Phillips curve
INFLATION AND UNEMPLOYMENT:THE PHILLIPS CURVE
The Short-Run Phillips Curve The short-run Phillips curve is a
curve that shows the relationship between inflation and unemployment, holding constant: The expected inflation rate The natural unemployment rate
INFLATION AND UNEMPLOYMENT:THE PHILLIPS CURVE
The Short-Run Phillips Curve The negative relationship between
inflation and unemployment can be explained by the aggregate supply-aggregate demand model.
Unemployment rate (percentage of labour force)
Infl
atio
n ra
te (
perc
ent p
er y
ear)
5
3 6 9 120
A
SRPCNatural unemploymentrate
Expectedinflationrate
10
15
20
A SHORT-RUN PHILLIPS CURVE
C
B
Figure 29.10
Real GDP (billions of 2003/04 dollars)
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
100
LAS
SAS1
SAS0
AD0
113
110107
AD1
0
A
AS-AD AND THE SHORT-RUN PHILLIPS CURVE
800 900 950 1,050850 1,000
Figure 29.11(a)
100
LAS
SAS1
SAS0
AD0
113110107
AD2
0
B
A
AS-AD AND THE SHORT-RUN PHILLIPS CURVE
Real GDP (billions of 2003/04 dollars)800 900 950 1,050850 1,000
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
Figure 29.11(b)
100
LAS
SAS1
SAS0
AD0
113110107
0
A
C
B
AS-AD AND THE SHORT-RUN PHILLIPS CURVE
Real GDP (billions of 2003/04 dollars)800 900 950 1,050850 1,000
Pri
ce le
vel
(GD
P de
flat
or, 2
003/
04 =
100
)
Figure 29.11(c)
THE LONG-RUN PHILLIPS CURVE
The long-run Phillips curve is a curve that shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. It shows that any anticipated inflation
rate is possible at the natural unemployment rate.
Therefore, when inflation is anticipated, real GDP equals potential GDP.
SRPC1
Unemployment rate (percentage of labour force)
Infl
atio
n ra
te (
perc
ent p
er y
ear)
5
3 6 9 120
Decreases in expectedinflation shifts short-runPhillips curve downward
10
15
20 LRPC
7 SRPC0
A
SHORT-RUN AND LONG RUN PHILLIPS CURVES
C
B
Figure 29.12
CHANGES IN THE NATURAL UNEMPLOYMENT RATE
The natural unemployment rate may change for many reasons.
This shifts both the short-run and long-run Phillips curves.
LRPC1
Unemployment rate (percentage of labour force)
Infl
atio
n ra
te (
perc
ent p
er y
ear)
5
3 6 9 120
10
15
20 LRPC0
Increase in natural unemployment rateshifts LRPC andSRPC rightward
SRPC0
SRPC1
EA
A CHANGE IN THENATURAL UNEMPLOYMENT RATE
Figure 29.13
INTEREST RATES AND INFLATION
Interest rates vary across countries partly because risk differences make real interest rates vary across countries, and partly due to the fact that inflation rates vary across countries.
The higher the expected inflation rate, the higher the nominal interest rate.
HOW INTEREST RATES ARE DETERMINED
Why Inflation Influences the Nominal Interest Rate As the expected inflation rate rises,
borrowers willingly pay a higher interest rate and lenders successfully demand a higher interest rate
The nominal interest rate adjusts to equal the real interest rate plus the expected inflation rate