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ECONOMICS 5e
Michael Parkin
CHAPTER
16
Inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Chapter 33 in Economics
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Learning Objectives
• Distinguish between inflation and a onetime rise in the price level
• Explain the different ways in which
inflation can be generated
• Describe how people try to forecast
inflation
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Learning Objectives (cont.)
• Explain the short-run and long-run
relationships between inflation and
unemployment
• Explain the short-run and long-run
relationships between inflation and interest
rates
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 16-‹#›
Learning Objectives
• Distinguish between inflation and a onetime rise in the price level
• Explain the different ways in which
inflation can be generated
• Describe how people try to forecast
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
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Inflation and the Price Level
• Inflation is a 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.
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Inflation and the Price Level
• A one-time jump in the price level is not
inflation.
• Inflation is an ongoing process.
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Inflation Versus a One-Time
Rise in the Price Level
Price level (1992 = 100)
160
150
140
Inflation, ongoing
process of rising
price level
130
120
110
A one-time rise
in the price level
100
90
1992 1993 1994 1995 1996 1997
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Inflation and the Price Level
To calculate the inflation rate, the difference
in the price level of the two years is divided
by the first year’s price level.
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Inflation and the Price Level
For example, if this year’s price level is 126
and last years was 120, then inflation is:
126 – 120
Inflation Rate 
 100
120
 5 percent per year.
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Learning Objectives
• Distinguish between inflation and a onetime rise in the price level
• Explain the different ways in which
inflation can be generated
• Describe how people try to forecast
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
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Inflation and the Price Level
There are two sources of pressure on the
price level and inflation:
1) Demand pull
2) Cost push
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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 money supply
• Increase in government purchases
• Increase in exports
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Demand-Pull Inflation
Inflation Effect of an Increase in Aggregate
Demand
If an event leads to an increase in aggregate
demand when the real GDP equals potential
GDP, both GDP and the price level will
increase initially.
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Demand-Pull Inflation
Wage Response
• However, a shortage of labor 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 potential GDP.
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Price level
(GDP deflator, 1992 = 100)
A Demand-Pull Rise inIncrease
thein AD
Price Level
LAS
130
121
raises price level
and increases
real GDP...
SAS1
(cont.)
SAS0
113
110
100
0
AD1
…wages rise, and
SAS shifts leftward.
Price level rises
further, and real
GDP declines
AD0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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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.
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Price level
(GDP deflator, 1992 = 100)
A Demand-Pull Inflation Spiral
LAS
SAS2
133
125
121
113
110
SAS1
SAS0
Repeated increases
in AD create a
price-wage spiral
AD2
AD1
AD0
0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Demand-Pull Inflation
Demand-Pull Inflation in the United States
• A series of events similar to this occurred in the
U.S. during the 1960s.
• Government spending increased for Vietnam
and social programs.
• The growth rate of money increased.
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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.
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Cost-Push Inflation
Initial Effect of a Decrease in Aggregate
Supply
• If the price of oil were to increase dramatically
(supply shock) the short-run aggregate supply
curve would shift leftward.
• The price level would rise and real GDP would
decline.
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Cost-Push Inflation
Initial Effect of a Decrease in Aggregate
Supply
• Stagflation is the combination of a rise in the
price level and a decrease in real GDP.
• This one time event is not inflation.
• Other things must occur for this to be converted
into a process of money supply growth and
ongoing inflation.
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Price level
(GDP deflator, 1992 = 100)
A Cost-Push Rise in the Price Level
LAS
Resource price rise
shifts SAS leftward
and causes stagflation
130
SAS1
120
117
SAS0
110
100
0
AD0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Cost-Push Inflation
Aggregate Demand Response
• When real GDP falls, unemployment rises
above the full employment rate.
• The Fed may respond by increasing the money
supply.
• Aggregate demand increases.
• Full employment has been restored, but prices
have increased further.
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Price level
(GDP deflator, 1992 = 100)
Aggregate Demand
Response to Cost Push
LAS
130
121
117
SAS1
SAS0
110
AD1
100
0
Factor price rise
shifts SAS leftward
and causes inflation.
The Fed increases AD
to restore fullemployment and the
price level rises again.
AD0
6.0 6.5
7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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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.
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Price level
(GDP deflator, 1992 = 100)
A Cost-Push Inflation Spiral
LAS
133
129
SAS2
SAS1
SAS0
121
117
110
Oil producers and the
Fed feed cost-price
inflation spiral
AD2
AD1
AD0
0
6.0 6.5
7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Cost-Push Inflation
Cost-Push Inflation in the United States
• OPEC in the 1970s increased the price of oil
four times its original price.
• The Fed allowed the money supply to
continually grow.
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Cost-Push Inflation
Cost-Push Inflation in the United States
• In 1980 OPEC again increased the price of oil.
• The Fed did not respond.
• A recession followed, but inflation decreased.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 16-‹#›
Learning Objectives
• Distinguish between inflation and a onetime rise in the price level
• Explain the different ways in which
inflation can be generated
• Describe how people try to forecast
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 16-‹#›
Effects of Inflation
Unanticipated Inflation in the Labor Market
Two consequences of unanticipated inflation in
the labor market are:
1) Redistribution of income.
2) Departure from full employment.
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Effects of Inflation
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.
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Effects of Inflation
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.
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Effects of Inflation
Departure from Full Employment
Underestimating the inflation rate leads to:
• Less real incomes for workers.
• Employers cannot find adequate labor.
• Employees begin to quit.
• Firms incur labor turnover costs.
Production is below what it would have been
had the inflation rate been correctly anticipated.
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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.
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Effects of Inflation
Unanticipated Inflation in the Capital Market
Two consequences of unanticipated inflation in the
capital market are:
1) Redistribution of income.
2) Too much or too little lending and borrowing.
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Effects of Inflation
Redistribution of Income
• Unanticipated inflation leads to interest rates not
being set high enough to compensate lenders.
• Borrowers gain, lenders lose.
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Effects of Inflation
Redistribution of Income (cont.)
• If inflation is below what had been anticipated,
interest rates will be set too high.
• Lenders gain, borrowers lose.
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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.
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Effects of Inflation
Too Much or Too Little Lending and Borrowing
If inflation is lower than expected:
• Borrowers wish they had borrowed less
• Lenders wish they had lent more
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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.
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Effects of Inflation
Anticipated Inflation
• Money wages are assumed to be sticky while an
economy is experiencing demand-pull and costpush inflation.
• Correctly anticipating increases in the price level,
people will adjust their money wage rates to
compensate.
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Price level
(GDP deflator, 1992 = 100)
Anticipated Inflation
LAS
133
SAS2
SAS1
SAS0
121
110
AD2
AD0
0
Anticipated increases
in AD bring inflation
but no change in
real GDP
6.0 6.5
AD1
7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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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.
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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
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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.
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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.
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Effects of Inflation
Increases Uncertainty
• High inflation rates result in uncertainty about the
long-term inflation rate.
• Investment falls.
• Growth falls.
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Learning Objectives (cont.)
• Explain the short-run and long-run
relationships between inflation and
unemployment
• Explain the short-run and long-run
relationships between inflation and interest
rates
Copyright © 2000 Addison Wesley Longman, Inc.
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Inflation and Unemployment:
The Phillips Curve
The Phillips curve shows the relationship
between inflation and unemployment.
There are two types of Phillips curves:
• The short-run Phillips curve
• The long-run Phillips curve
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Inflation and Unemployment:
The Phillips Curve
The Short-Run Phillips Curve
The short-run Phillips curve is a curve that
shows the tradeoff between inflation and
unemployment, holding constant:
• The expected inflation rate
• The natural unemployment rate
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Inflation and Unemployment:
The Phillips Curve
The Short-Run Phillips Curve (cont.)
The negative relationship between inflation and
unemployment can be explained by the
aggregate supply-aggregate demand model.
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Inflation rate (percent per year)
A Short-Run Phillips Curve
20
15
b
a
10
5
0
c
SRPC
Expected
inflation
rate
3
Natural
unemployment
rate
6
9
12
Unemployment rate (percentage of labor force)
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Price level
(GDP deflator, 1992 = 100)
AS-AD and the
Short-Run Phillips Curve
LAS
b
113
110
107
SAS1
SAS0
a
c
100
AD2
AD1
AD0
0
6.0
6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Inflation and Unemployment:
The Phillips Curve
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 irate.
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Inflation and Unemployment:
The Phillips Curve
The Long-Run Phillips Curve
• It shows that any anticipated inflation rate is
possible at the natural unemployment rate.
• Therefore, when inflation is anticipated, real
GDP equals potential GDP.
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Inflation rate (percent per year)
Short-Run and Long Run
Phillips Curves
LRPC
20
Decreases in expected
inflation shifts short-run
Phillips curve downward
15
a
10
c
7
5
0
SRPC0
b
SRPC1
3
6
9
12
Unemployment rate (percentage of labor force)
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Inflation and Unemployment:
The Phillips Curve
Changes in the Natural Unemployment Rate
• As studied earlier, the natural unemployment
rate may change for several reasons.
• This shifts both the short-run and long-run
Phillips curves.
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Inflation rate (percent per year)
A Change in the
Natural Unemployment Rate
LRPC0
20
LRPC1
Increase in natural
unemployment rate
shifts LRPC and
SRPC rightward
15
a
10
e
SRPC1
SRPC0
5
0
3
6
9
12
Unemployment rate (percentage of labor force)
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Phillips Curves in the United States
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Phillips Curves in the United States
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Learning Objectives (cont.)
• Explain the short-run and long-run
relationships between inflation and
unemployment
• Explain the short-run and long-run
relationships between inflation and interest
rates
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Interest Rates and Inflation
The Effects of Inflation on Borrowers and
Lenders
The nominal interest rate is the price a borrower
pays a lender for two things:
• The amount loaned
• The devaluing of the money that results from
inflation
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Interest Rates and Inflation
The Effects of Inflation on Borrowers and
Lenders (cont.)
The real interest rate is the price paid by a
borrower to compensate a lender only for the
amount loaned.
The forces of demand and supply determine
both the nominal and real interest rates.
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Interest Rates and Inflation
The Effects of Inflation on Borrowers and
Lenders (cont.)
• When inflation is anticipated, the nominal
interest rate increases by an amount equal to the
expected inflation rate.
• The real interest rate remains constant.
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Interest Rates and Inflation
Inflation and Interest Rates in the United
States
• A positive relationship has existed between
inflation rates and interest rates.
• However, the real interest rate has not been
constant.
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Inflation and the Interest Rate
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Inflation and the Interest Rate
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The End
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