IB; AD/AS & inflation

Monetary & Fiscal Policy teams meet

at lunchtime on Thursdays
Cost-push & demand-pull inflation
Inflation can be caused by cost-push and
demand-pull.

To understand these, we need to understand
the aggregate demand and supply.
AD
Aggregate demand; aggregate is the total.
Aggregate Demand is the total demand
(spending) for goods, services and raw
materials in the economy/nation.
On the circular flow of income,
AD = C + I + G + (X - M).
Where C is Consumption spending, I is
investment spending, G is government
spending, and X M is exports imports.
Circular Flow
Increases
AD = Gross Domestic Product, or the total
amount of spending on goods, services,
investment and foreign spending in the
economy.
GDP = Y = AD = C + I + G + (X M).
All of the output is compared to the price
level.
Note; NOT prices on the y axis, but general
price level.
Real
The word real means after inflation.
If inflation is 2%, and the growth is 3%, then the
real growth is only 1%.
2% is being eaten up by merely increases in
prices.

Just as an increase in your pocket money is pointless
if the prices go up, similarly a growth in the economy
can only be worked out after inflation.
AD
AD
The components of AD are Y = C + I + G + (X
M).
If one increases, AD shifts right. A decrease in
one means a left shift.

For example, the Rugby World Cup causes
increased consumption spending. AD right.
AD = Y = GDP = C + I + G + (X M).
Shifts
AD decreases
Many reasons; consumers stop spending.
Government spends less.
Firms invest less.
New Zealand exports decrease.

AD will shift left at all price levels.
AD decreases
Right Shifts in AD
AD shifts right when C, I, G and (X-M) increases.
For example, consumers feel confident and spend
more.
Companies feel confident and so invest in
projects for the future.
The government spends more on infrastructure
projects (roads, railways, cycle tracks, housing,
teacher salaries).
Foreigners demand more of NZs high quality
green products.
Left Shifts in AD
If there are fears of future unemployment or
other economic problems, then C will fall.
Firms will cut back on future projects if they think
there will be a downturn in the economy. So I will
decrease.
If the government cuts back spending, e.g.
reducing welfare, health care, education and
spending on administration or the police or
armed services. G will decrease.
If there is a recession in our export partners, and
X decreases AD shifts left.
Demand Pull
Illustrated as:

Issues
Explain why it is important to know where an
economy is when there is a shift in Aggregate
Demand.

Discuss whether you would stimulate the NZ (or
other) economy at the moment by, for example,
lowering interest rates.
Explain how the interest rates affect AD, discuss
where the economy is at the moment, and thus
whether inflation is a problem.
Cost-push inflation
What are the constituents of Aggregate
Supply?
The costs of production; the cost of labour, of
raw materials, of capital, of land, and of
entrepreneurial skills.
An increase in the costs of production will
shift the Short Run Aggregate Supply to the
left.
AS left shift
Examples
The major, much-quoted, example of cost-
push inflation is oil price increases.
But also minimum wage increases,
a change in the price of imports for
production (eg a decrease in currency causes
essential raw materials to become more
expensive),
increases in company tax.
Demand-pull vs cost-push
While demand pull means an increase in
output (thus employment of resources),
An increase in cost-push means a decrease in
output (so unemployment).

Which concerns most politicians?
Inflationary spiral
Check page 314.
See the problem of an inflationary spiral.