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INFLATION
28
CHAPTER
Objectives
After studying this chapter, you will able to
ƒ Distinguish between inflation and a one-time rise in the
price level
ƒ Explain how demand-pull inflation is generated
ƒ Explain how cost-push inflation is generated
ƒ Explain the quantity theory of money
ƒ Describe the effects of inflation
ƒ Explain the short-run and long-run relationships between
inflation and unemployment
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From Rome to Rio de Janeiro
ƒ Explain the short-run and long-run relationships between
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inflation and interest rates
Inflation and the Price Level
Inflation is a very old problem and some countries even in
recent times have experienced rates as high as 40% per
month.
Inflation is a process in which the price level is rising and
money is losing value.
Canada has low inflation now, but during the 1970s the
price level doubled.
Inflation is a rise in the price level, not in the price of a
particular commodity.
Why does inflation occur, how do our expectations of
inflation influence the economy, is there a tradeoff
between inflation and unemployment, and how does
inflation affect the interest rate?
And inflation is an ongoing process, not a one-time jump in
the price level.
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Inflation and the Price Level
Figure 28.1 illustrates the
distinction between
inflation and a one-time
rise in the price level.
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Inflation and the Price Level
The inflation rate is the percentage change in the price
level.
That is, where P1 is the current price level and P0 is last
year’s price level, the inflation rate is
[(P1 – P0)/P0] × 100
Demand-Pull Inflation
Demand-pull inflation is an inflation that results from an
initial increase in aggregate demand.
Demand-pull inflation may begin with any factor that
increases aggregate demand.
Inflation can result from either an increase in aggregate
demand or a decrease in aggregate supply and be
Two factors controlled by the government are increases in
the quantity of money and increases in government
purchases.
ƒ Demand-pull inflation
A third possibility is an increase in exports.
ƒ Cost-push inflation
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Demand-Pull Inflation
Initial Effect of an
Increase in Aggregate
Demand
Figure 28.2(a) illustrates
the start of a demand-pull
inflation
Starting from full
employment, an increase
in aggregate demand
shifts the AD curve
rightward.
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Demand-Pull Inflation
The price level rises, real
GDP increases, and an
inflationary gap arises.
The rising price level is the
first step in the demandpull inflation.
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Demand-Pull Inflation
Money Wage Rate
Response
Figure 28.2(b) illustrates
the money wage response.
The money wages rises
and the SAS curve shifts
leftward.
Real GDP decreases back
to potential GDP but the
price level rises further.
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Demand-Pull Inflation
A Demand-Pull Inflation
Process
Figure 28.3 illustrates a
demand-pull inflation
spiral.
Aggregate demand keeps
increases and the process
just described repeats
indefinitely.
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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 Canada during
the late 1960s and early
1970s.
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Cost-Push Inflation
Cost-push inflation is an inflation that results from an
initial increase in costs.
There are two main sources of increased costs
ƒ An increase in the money wage rate
ƒ An increase in the money price of raw materials, such as
oil.
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Cost-Push Inflation
Initial Effect of a
Decrease in Aggregate
Supply
Figure 28.4 illustrates the
start of cost-push inflation.
A rise in the price of oil
decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
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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.
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Cost-Push Inflation
Aggregate Demand Response
The initial increase in costs creates a one-time rise in the
price level, not inflation.
To create inflation, aggregate demand must increase.
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Cost-Push Inflation
Figure 28.5 illustrates an
aggregate demand
response to stagflation,
which might arise because
the Bank of Canada
stimulates demand to
counter the higher
unemployment rate and
lower level of real GDP.
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Cost-Push Inflation
The increase in aggregate
demand shifts the AD
curve rightward.
Real GDP increases and
the price level rises again.
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Cost-Push Inflation
A Cost-Push Inflation
Process
Figure 28.6 illustrates a
cost-push inflation spiral.
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Cost-Push Inflation
If the oil producers raise
the price of oil to try to
keep its relative price
higher, and the Bank of
Canada responds with an
increase in aggregate
demand, a process of
cost-push inflation
continues.
Cost-push inflation
occurred in Canada during
1974–1978.
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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.
The quantity theory of money is based on the velocity of
circulation and the equation of exchange.
The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods and
services in GDP.
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The Quantity Theory of Money
Calling the velocity of circulation V, the price level P, real
GDP Y, and the quantity of money M
V = PY ÷ M
The equation of exchange states that
MV = PY
The equation of exchange becomes the quantity theory of
money by making two assumptions:
1. V is not influenced by M
2. Potential GDP is not influenced by M
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The Quantity Theory of Money
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The Quantity Theory of Money
That is, the change in P, ∆P, is related to the change in M,
∆M, by the equation:
Given these two assumptions:
P = (V/Y)M
Because (V/Y) does not change when M changes, a
change in M brings a proportionate change in P.
∆P = (V/Y)∆M
Divide this equation by
P = (V/Y)M
and the term (V/Y) cancels to give
∆P/P = ∆M/M
∆P/P is the inflation rate and = ∆M/M is the growth rate of
the quantity of money.
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The Quantity Theory of Money
The Quantity Theory of Money
Evidence on the Quantity Theory
Canadian historical evidence is consistent with the
quantity theory.
1. On the average, the money growth rate exceeds the
inflation rate
2. The money growth rate is correlated with the inflation
rate.
The next slide shows Figure 28.7, which summarizes
the Canadian data on inflation and money growth for the
years 1971-2001.
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The Quantity Theory of Money
International evidence
shows a marked tendency
for high money growth rates
to be associated with high
inflation rates.
Figure 28.8(a) shows the
evidence for 60 countries
during the 1980s.
Figure 28.8(b) shows the
evidence for 13 regions and
countries during the 1990s.
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The Quantity Theory of Money
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Effects of Inflation
Correlation, Causation, and Other Influences
Correlation is not causation; money growth and inflation
could be correlated because money growth causes
inflation, or because inflation causes money growth, or
because a third factor caused both.
But the combination of historical, international, and other
independent evidence gives us confidence that in the long
run, money growth causes inflation.
Unanticipated Inflation in the Labour Market
Unanticipated inflation has two main consequences in the
labour market:
ƒ Redistributes of income
ƒ Departure from full employment
In the short run, the quantity theory is not correct; we need
the AS-AD model to understand the links between money
and inflation.
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Effects of Inflation
Higher than anticipated inflation lowers the real wage rate
and employers gain at the expense of workers.
Lower than anticipated inflation raises the real wage rate
and workers gain at the expense of employers.
Higher than anticipated inflation lowers the real wage rate,
increases the quantity of labour demanded, makes jobs
easier to find, and lowers the unemployment rate.
Lower than anticipated inflation raises the real wage rate,
decreases the quantity of labour demanded, and
increases the unemployment rate.
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Effects of Inflation
When the inflation rate is higher than anticipated, the real
interest rate is lower than anticipated, and borrowers want
to have borrowed more and lenders want to have loaned
less.
When the inflation rate is lower than anticipated, the real
interest rate is higher than anticipated, and borrowers
want to have borrowed less and lenders want to have
loaned more.
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Effects of Inflation
Unanticipated Inflation in the Market for Financial
Capital
Unanticipated inflation has two main consequences in the
market for financial capital: it redistributes income and
results in too much or too little lending and borrowing.
If the inflation rate is unexpectedly high, borrowers gain
but lenders lose.
If the inflation rate is unexpectedly low, lenders gain but
borrowers lose.
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Effects of Inflation
Forecasting Inflation
To minimize the costs of incorrectly anticipating inflation,
people form rational expectations about the inflation rate.
A rational expectation is one based on all relevant
information and is the most accurate forecast possible,
although that does not mean it is always right; to the
contrary, it will often be wrong.
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Effects of Inflation
Anticipated Inflation
Figure 28.9 illustrates an
anticipated inflation.
Aggregate demand
increases, but the increase
is anticipated, so its effect
on the price level is
anticipated.
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Effects of Inflation
The money wage rate
rises in line with the
anticipated rise in the price
level.
The AD curve shifts
rightward and the SAS
curve shifts leftward so
that the price level rises as
anticipated and real GDP
remains at potential GDP.
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Effects of Inflation
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Effects of Inflation
Unanticipated Inflation
If aggregate demand increases by more than expected,
inflation is higher than expected.
Money wages do not adjust enough, and the SAS curve
does not shift leftward enough to keep the economy at full
employment.
The economy experiences more inflation as it returns to
full employment.
This inflation is like a demand-pull inflation.
Real GDP exceeds potential GDP.
Wages eventually rise, which leads to a decrease in the
SAS.
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Effects of Inflation
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Effects of Inflation
The Costs of Anticipated Inflation
If aggregate demand increases by less than expected,
inflation is less than expected.
Anticipated inflation occurs at full employment with real
GDP equal to potential GDP.
Money wages rise too much and the SAS curve shifts
leftward more than the AD curve shifts rightward.
But anticipated inflation, particularly high anticipated
inflation, inflicts three costs
Real GDP is less than potential GDP.
ƒ Transactions costs
This inflation is like a cost-push inflation.
ƒ Tax effects
ƒ Increased uncertainty
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Inflation and Unemployment:
The Phillips Curve
A Phillips curve is a curve that shows the relationship
between the inflation rate and the unemployment rate.
Inflation and Unemployment:
The Phillips Curve
The Short-Run Phillips Curve
There are two time frames for Phillips curves
The short-run Phillips curve shows the tradeoff between
the inflation rate and unemployment rate holding constant
ƒ The short-run Phillips curve
ƒ The expected inflation rate
ƒ The long-run Phillips curve
ƒ The natural unemployment rate
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Inflation and Unemployment:
The Phillips Curve
Figure 28.10 illustrates a
short-run Phillips curve
(SRPC)—a downwardsloping curve.
If the unemployment rate
falls, the inflation rate
rises.
And if the unemployment
rate rises, the inflation rate
falls.
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Inflation and Unemployment:
The Phillips Curve
The negative relationship
between the inflation rate
and unemployment rate is
explained by the AS-AD
model.
Figure 28.11 shows how.
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10
Inflation and Unemployment:
The Phillips Curve
Aggregate demand is
expected to increase to AD1
so the money wage rate
rises and the short run
aggregate supply curve
shifts to SAS1.
If this outcome occurs, the
inflation rate is 10 percent
and unemployment is at the
natural rate.
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Inflation and Unemployment:
The Phillips Curve
An unexpectedly large
increase in aggregate
demand raises the inflation
rate and increases real
GDP, which lowers the
unemployment rate.
A higher inflation is
associated with a lower
unemployment, as shown
by a movement along a
short-run Phillips curve.
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Inflation and Unemployment:
The Phillips Curve
An unexpectedly small
increase in aggregate
demand lowers the inflation
rate and decreases real
GDP, which raises the
unemployment rate.
A lower inflation is
associated with a higher
unemployment, as shown
by a movement along a
short-run Phillips curve.
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Inflation and Unemployment:
The Phillips Curve
The Long-Run Phillips Curve
The long-run Phillips curve shows the relationship
between inflation and unemployment when the actual
inflation rate equals the expected inflation rate.
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Inflation and Unemployment:
The Phillips Curve
Figure 28.12 illustrates the
long-run Phillips curve
(LRPC) which is vertical at
the natural rate of
unemployment.
Along the long-run Phillips
curve, because a change
in the inflation rate is
anticipated, it has no effect
on the unemployment rate.
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Inflation and Unemployment:
The Phillips Curve
Figure 28.12 also shows
how the short-run Phillips
curve shifts when the
expected inflation rate
changes.
A lower expected inflation
rate shifts the short-run
Phillips curve downward
by an amount equal to the
fall in the expected
inflation rate.
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Inflation and Unemployment:
The Phillips Curve
Here, the expected
inflation rate falls from 10
percent a year to 7 percent
a year.
With an expected inflation
rate of 10 percent a year,
an actual inflation rate of 7
percent a year would
mean a 9 percent
unemployment rate at
point C.
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Inflation and Unemployment:
The Phillips Curve
Changes in the Natural
Unemployment Rate
A change in the natural
unemployment rate shifts
both the long-run and
short-run Phillips curves.
Figure 28.13 illustrates.
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Inflation and Unemployment:
The Phillips Curve
The Canadian Phillips
Curve
The data for Canada are
consistent with a shifting
short-run Phillips curve.
The Phillips curve has
shifted because of
changes in the expected
inflation rate and
changes in the natural
rate of unemployment.
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Inflation and Unemployment:
The Phillips Curve
Figure 28.14 (a) shows
the actual path traced
out in inflation rateunemployment rate
space.
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13
Inflation and Unemployment:
The Phillips Curve
Figure 28.14(b)
interprets the data with
shifting short-run and
long-run Phillips curves.
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Interest Rates and Inflation
Interest rates and
inflation rates are
correlated, although
they differ around the
world.
Figure 28.15(a) shows a
positive correlation
between the inflation
rate and the nominal
interest rate over time in
Canada.
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Interest Rates and Inflation
Figure 28.15(b) shows
a positive correlation
between the inflation
rate and the nominal
interest rate across
countries.
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Interest Rates and Inflation
How Interest Rates are Determined
The real interest rate is determined by investment demand
and saving supply in the global capital market.
The real interest rate adjusts to make the quantity of
investment equal the quantity of saving.
National rates vary because of differences in risk.
The nominal interest rate is determined by the demand for
money and the supply of money in each nation’s money
market.
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Interest Rates and Inflation
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INFLATION
28
CHAPTER
Why Inflation Influences the Nominal Interest Rate
Inflation influences the nominal interest rate to maintain an
equilibrium real interest rate.
THE
END
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