Download Chapter 6 INFLATION

ECON 141: Macroeconomics
Inflation
DEFINITION OF INFLATION
• Inflation is a process of continuous
(persistent) increase in the price level.
• Inflation results in a decrease of the value
of money.
• In the definition of inflation we have to
observe
b
that:
th t
1. Inflation is an increase in the prices of all
goods and services not only of a particular
good or service.
2. Inflation is an ongoing process, not a onetime jump in the price level.
Chapter 6
INFLATION
Dr. Mohammed Alwosabi
INFLATION RATE:
• To measure the inflation rate, we calculate
the annual percentage change in the price
level.
Inflation
Rate
=
P this
year
- P last year
× 100
P last year
• we measure the price level (P) of a country
using GDP Deflator or CPI.
Inflation Rate =
Inflation
GDP Deflator
Rate =
this year
- GDP Deflator
GDP Deflator
CPI
this year
CPI
last year
× 100
last year
- CPI
last year
Dr. Mohammed Alwosabi
× 100
last year
Demand-Pull Inflation
• Demand-pull inflation is a result of the
increase in spending is faster than the
increase in production of output.
• Demand-pull inflation starts as AD
increases and AD curve shifts rightward.
• An
A iincrease iin aggregate
t demand
d
d is
i
caused mainly by
1. the increase in quantity of money (Qm),
2. the increase in any of C, I, G, or X
CAUSES OF INFLATION
• The inflation can result from either
1. an increase in aggregate demand
(demand-pull inflation), or
2. a decrease in aggregate supply (cost-push
inflation)
• Nevertheless, the direct source of inflation
is the high growth rate of money supply
with.
• Milton Friedman proposed that "inflation is
always and everywhere a monetary
phenomenon".
•
• The Process of Demand-Pull Inflation
P
LAS
SAS3
SAS2
E
P4
D
P3
SAS1
C
P2
AD3
B
P1
A
P0
AD2
AD1
Y
Y0
Y1
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ECON 141: Macroeconomics
Inflation
Dr. Mohammed Alwosabi
• Suppose in the last year, the economy is at
LR full employment equilibrium point A,
where LAS, AD0 and SAS0 intersect with
each other.
• At this point, RGDP = PGDP and P = P0.
• In the current year, an increase in Qm, C, I,
G or X leads to an increase in AD ⇒ AD
G,
curve shifts rightward from AD0 to AD1 ⇒
the new SR equilibrium is at point B,
• At B, RGDP is greater than PGDP, price
level increases from P0 to P1, ⇒ real wage
rate has decreased and unemployment
falls below its natural rate (above FE) ⇒
there is a shortage of labor ⇒ money wage
rate starts to increase to attract more labor
⇒ SAS starts to decrease ⇒ SAS curve
starts to shift leftward ⇒ P starts to
increase and RGDP starts to decrease until
SAS curve shifted to SAS1 where it
intersects AD1 and LAS at point C
• At point C, RGDP goes back to its potential
LR and FE level (Y0) and the price level
increase further to P2.
• This process is only a one-time rise in P. For
inflation to proceed, AD must persistently
increase.
• Since now the money wage is higher which
means people can spend more and as a
result P is higher (P2), the only result is the
increase in Qm ⇒ increase in AD ⇒ AD
curve will shift from AD1 to AD2 ⇒ the
process will continue ⇒ higher price level
(inflation)
• This is an ongoing process of rising price
level.
Cost-Push Inflation
• Cost-push inflation arises due to a
decrease in supply as a result of the rise in
the per unit cost of production, mainly
because of the
1. increase in wage rates
2 increase
2.
i
in
i the
th prices
i
off key
k raw materials
t i l
(e.g. oil price)
• Cost-push inflation starts as SAS increases
and SAS curve shifts leftward.
• At a given price level, the higher the cost of
production, because of an increase in the
money wage rate or an increase in the
prices of raw material, the smaller is the
amount that firms are willing to produce ⇒
SAS decreases ⇒ SAS shifts leftward ⇒ an
increase in prices and unemployment and a
decrease in RGDP ⇒ stagflation
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ECON 141: Macroeconomics
Inflation
• The Process of Cost-Push Inflation
LAS
P
SAS3
SAS2
E
P4
SAS1
D
P3
C
P2
AD3
B
P1
A
P0
AD2
AD1
Y1
Y
Y0
Dr. Mohammed Alwosabi
• Suppose price level was P0 and PGDP is
Y0, where AD0, SAS0 and LAS intersect at
point A, LR FE equilibrium. If nominal
wages or prices of other factors of
production ⇒ production cost ⇒ firms
reduce production ⇒ SAS ⇒ SAS curve
shifts leftward to SAS2 to p
point B.
• At point B, price level increases to P1 and
RGDP decreases to Y1 and therefore
unemployment increases above its natural
rate (below FE) ⇒ the combination of a rise
in P and a fall in RGDP (and a rise in
unemployment) is called stagflation.
• As a response to the increase in P and a
decrease in RGDP, government increases
Qm ⇒ AD increases ⇒ AD curve starts to
shift rightward until it reaches AD1 at point
C, where AD1 intersects with SAS1 and LAS.
• At point C, the economy is at higher price
level (P2) and RGDP goes back to PGDP (Y0)
at full employment
• With the new higher price, money wage rate
and prices of other productive resources
start to increase again which leads to
increase in the cost of production ⇒ SAS
curve will shift leftward from SAS1 to SAS2
⇒ stagflation ⇒ the process will be
repeated
p
⇒ higher
g
price
p
level (inflation)
(
)
• This is an ongoing process of rising price
level.
• Note that a one-time increase in the price of
one resource without any following change
in AD produces stagflation but not inflation.
EFFECTS OF INFLATION
• Inflation may be anticipated (expected) or
unanticipated (unexpected)
• A moderate anticipated (expected) has a
small cost, but a rapid anticipated inflation
is costly because it decreases potential GDP
and slow growth.
growth
• Unanticipated (unexpected) inflation has
two main consequences in the labor market.
(1) It redistributes income and
(2) It results in the departure from full
employment
1. Higher than anticipated inflation
(unexpectedly high) ⇒ lowers the real
wage rate ⇒ employers gain at the
expense of workers ⇒ increases the
quantity of labor demanded, makes jobs
easier to find, and lowers the
unemployment
p y
rate.
2. Lower than anticipated inflation
(unexpectedly low) ⇒ raises the real wage
rate ⇒ workers gain at the expense of
employers ⇒ decreases the quantity of
labor demanded, and increases the
unemployment rate.
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ECON 141: Macroeconomics
Inflation
3. If workers and employers base their wages
on an inflation forecast that turns out to be
correct, neither workers nor employers
gain or lose from the inflation.
•
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.
INFLATION AND UNEMPLOYMENT: THE
PHILLIPS CURVE
• Phillips curve shows the inverse
relationship between inflation rate (IR) and
unemployment rate (UR).
• There are two time frames for Phillips
curves
• The short-run Phillips curve
• The long-run Phillips curve
• Our focus here is only on the SR Phillips
curve.
IR
B
EIR
A
C
SRPC
UR
0
NRU
Dr. Mohammed Alwosabi
1. When the inflation rate is higher than
anticipated (unexpectedly high) ⇒ the real
interest rate is lower than anticipated ⇒
borrowers gain but lenders lose ⇒
borrowers want to have borrowed more
and lenders want to have loaned less.
2. When the inflation rate is lower than
anticipated (unexpectedly low) ⇒ the real
interest rate is higher than anticipated ⇒
lenders gain but borrowers lose ⇒
borrowers want to have borrowed less and
lenders want to have loaned more
• The SR Phillips curve (SRPC) slopes
downward to show the tradeoff between
inflation rate and unemployment rate
holding constant both the expected inflation
rate (EIR) and the natural rate of
unemployment (NRU).
• If inflation rises above its expected rate,
Unemployment falls below its natural rate.
This is represented by the movement from
point A to point B along SRPC.
• If inflation rate falls below its expected rate,
unemployment rises above its natural rate.
This is represented by the movement from
point A to point C along SRPC.
• Movements downward along the short-run
Phillips curve result from unanticipated
decreases in aggregate demand.
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ECON 141: Macroeconomics
Inflation
• An increase in the expected inflation rate or
natural rate of unemployment shifts the
short-run Phillips curve rightward.
• SRPC is like SAS curve. A movement along
SAS curve that brings a higher price level
and an increase in RGDP is equivalent to a
movement along SRPC that brings an
increase in the inflation rate and a decrease
in the unemployment rate
Dr. Mohammed Alwosabi
• Similarly, a movement along SAS curve that
brings a lower price level and a decrease in
RGDP is equivalent to a movement along
SRPC that brings a decrease in the inflation
rate and an increase in the unemployment
rate
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