2.

Inflation

2.1 Definition

Although today you need more than a dollar or tow to buy yourself an ice-cream, life was very different
50 year ago. If you were walking along the beach on a hot summer’s day and wanted to buy an ice-
cream, it would have cost you about 5 cents.

-The rapid monetary expansion during fiscal deficit: 151% in 1991 and 112% in 1992.

-From 1999 until 2006, the inflation rate stayed at less than 5% on average and then hiked to double digit
in 2007 and 2008 due to surge in oil and commodity prices.

-in after math of global economic crisis, the inflation begun declining to 5.3% in 2009 and down further
to 3.79% in 2011.

-Current assessment in that inflation is likely to rise to about 2.8 percent 2016 and head back to its
2014(3.9%) level by 2017.

2.2 The Causes of Inflation

Inflation can result from either an aggregate demand shock or an aggregate supply shock. These two
sources of impulses are called demand-pull inflation and cost-push inflation.

2.2.1 Demand-pull inflation

An inflation that results from an initial increases in aggregate demand is called demand-pull inflation.
Demand-pull inflation can arise from any factor that increase in aggregate demand, such as

-Increase in quantity of money

-Increase in government expenditure

-Increase in exports

2.2.1.1 Initial effect of an increase in aggregate demand

Suppose that last year the price level was 105 and real GDP was $18 billion. Potential GDP was also $18
billion. Figure (3.3) illustrates this situation. The aggregate demand curve is AD0, the short-run aggregate
supply curve is SAS0 and the long-run aggregate supply curve is LAS. In the current year, aggregate
demand increases to AD1. Such as situation arises if, for example, the central bank loosens its grip on the
quantity of money, or the government increases its expenditure on goods and services, or export
increase.

With no change in potential GDP, and with no change in money wage rate, the long-run aggregate supply
curve and the short-run aggregate supply curve remain at LAS and SASo, respectively. The price level and
real GDP are determined at the point where the aggregate demand curve AD1 curve intersects the short-
run aggregate supply. The price level rises to 108, and real GDP increases above potential GDP to $22
billion. The economy experiences a 2.2 % rise in the price level (a price level of 108 compared with 105 in
the previous year) and a rapid expansion of real GDP.
2.2.1.2. Money wage rate response

Real GDP cannot remain above potential GDP forever. With unemployment below its natural rate, there
is a shortage of labor. In this situation, the money wage rate begins to rise. As it does so, short-run
aggregate supply decrease and the SAS curve starts to shift leftward. The price level rise further, and real
GDP begins to decrease.

With no further change in aggregate demand, that is, the aggregate demand curve remains at AD1- this
process ends when the short-run aggregate supply curve has shifted to SAS1. At this time, the price level
has increased to 116 and real GDP has returned to potential GDP of $18, the level from which it started.

2.2.1.2. Money wage rate response

Real GDP cannot remain above potential GDP forever. With unemployment below its natural rate, there
is a shortage of labor. In this situation, the money wage rate begins to rise. As it does so, short-run
aggregate supply decrease and the SAS curve starts to shift leftward. The price level rise further, and real
GDP begins to decrease.

With no further change in aggregate demand, that is, the aggregate demand curve remains at AD1- this
process ends when the short-run aggregate supply curve has shifted to SAS1. At this time, the price level
has increased to 116 and real GDP has returned to potential GDP of $18, the level from which it started.

2.2.1.3. Demand-pull inflation process

The process we’ve studied eventually ends when, of a given increase in aggregate demand, the money
wage rate has adjusted enough to restore the real wage rate to its fullemployment level. We’ve studied a
one-time rise in the price level like that described in figure 3.4. For inflation to proceed, aggregate
demand must persistently increase.

The only way in which aggregate demand can persistently increase is if the quantity of money
persistently increases. Suppose the government has a budget deficit that is financed by selling bonds.
Also suppose that the central bank buys some of these bonds, resulting in increase in money supply in
the economy. Then, the aggregate demand increases year after year. The aggregate demand curve keeps
shifting rightward.

This persistent increase in aggregate demand puts continual upward pressure on the price level. The
economy now experiences demand-pull inflation

2.2.2. Cost-Push Inflation

An inflation that results from an initial increase in costs is called cost‐ push inflation. The two main
causes

• An increase in money wage rate

• An increase in money price of raw materials

At a given price level, the higher the cost of production, the shorter is the amount that firms are willing
to produce. So if money wage rates rise or if the price of raw materials (eg. oil) rise, firms decrease their
supply of goods and services. Aggregate supply decreases, and the short-run effect of such a decrease in
short-run aggregate supply on the price level and real GDP.
2.2.2.1. Initial effect of a decrease in aggregate supply

Suppose that last year the price level was 105 and real GDP was $18 billion. Potential GDP was also $18
billion.

‐ AD curve is AD0, the short‐run AS curve is SASo and the long‐run AS curve is LAS.

‐ Price of oil goes up, and this action decreases short‐run AS.

‐ The short‐run AS curve shifts leftward to SAS1

2.2.2.1. Initial effect of a decrease in aggregate supply

Suppose that last year the price level was 105 and real GDP was $18 billion. Potential GDP was also $18
billion.

‐ AD curve is AD0, the short‐run AS curve is SASo and the long‐run AS curve is LAS.

‐ Price of oil goes up, and this action decreases short‐run AS.

‐ The short‐run AS curve shifts leftward to SAS1

2.2.2.2. Aggregate Demand Response

-When real GDP falls, the unemployment rate rises above its natural rate.

‐ There is usually an outcry of concern and a call for an action to restore full employment.

. ‐ Suppose that the central bank increases the quantity of money which leads to increase in aggregate
demand, the AD curve shifts rightward to AD1. The increase in AD has restored full employment. But the
price level rises to 116, a 10 percent increase over the initial level.

‐ If the central bank increases the quantity of money, the AD increases and its curve shifts to AD2.

‐ The price rise even higher to 128 and full employment is again restored.