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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 1 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 2 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. 3 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. 4 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 5