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CHAPTER

Inflation

30

After studying this chapter you will be able to:

Distinguish between inflation and a one-time rise in the price level and explain how demand-pull inflation and cost-push inflation arise Explain the quantity theory of money Describe the effects of inflation Explain the short-run and long-run relationships between inflation and unemployment

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Demand-pull and Cost-push Inflation

Demand-pull and Cost-push Inflation

The inflation rate is the percentage change in the price level. That is, where P1 is the current price level and P0 is last years price level, the inflation rate is:

Inflation is a process in which the price level is rising and money is losing value. p , p Inflation is a rise in the price level, not in the price of a particular commodity. And inflation is an ongoing process, not a one-time jump in the price level.

(P1 - P0) P0

100

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Pearson Education 2008

Demand-pull and Cost-push Inflation

Demand-pull and Cost-push Inflation

Demand-pull Inflation

Inflation can result from either an increase in aggregate demand or a decrease in aggregate supply and be

Demand-pull inflation is an inflation that results from an initial increase in aggregate demand. p y g y Demand-pull inflation may begin with any factor that increases aggregate demand, such as: 1 Increase in the quantity of money 2 Increase in government expenditure 3 Increase in exports

Demand-pull inflation Cost-push inflation

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Demand-pull and Cost-push Inflation

Figure 30.2(a) illustrates the start of a demand-pull inflation. Starting from full employment, employment an increase in aggregate demand shifts the AD curve rightward.

Demand-pull and Cost-push Inflation

The price level rises, real GDP increases and an inflationary gap arises. The rising price level is the first step in the demand demandpull inflation.

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Demand-pull and Cost-push Inflation

Money Wage Rate Response Figure 30.2(b) illustrates the money wage response. The higher level of output Th hi h l l f t t means that real GDP exceeds potential GDP an inflationary gap.

Demand-pull and Cost-push Inflation

The money wages rises and the SAS curve shifts leftward. Note: money wage does not rise by the full extent of the rise in the price level in the short run. Real GDP decreases back to potential GDP gradually as the SAS curve shifts to the left.

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Demand-pull and Cost-push Inflation

In the long run, however, rise in the nominal wage becomes the same as the rise in the price level. Real wage comes back to the same state, employment and output comes back to the same level but the price level rises further.

Demand-pull and Cost-push Inflation

A Demand-pull Inflation Process Figure 30.3 illustrates a demand-pull inflation spiral. spiral If aggregate demand keeps increasing, the process just described repeats indefinitely.

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Demand-pull and Cost-push Inflation

Cost-push Inflation Cost-push inflation is an inflation that results from an initial increase in costs. There are two main sources of increased costs are: 1 An increase in the money wage rate 2 An increase in the money price of a raw material, such as oil.

Demand-pull and Cost-push Inflation

Figure 30.4 illustrates the start of cost-push inflation. Starting from long run equilibrium, a rise in the p price of oil decreases short-run aggregate supply and shifts the SAS curve leftward. Real GDP decreases and the price level rises. The rising price level is the start of the cost-push inflation.

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Demand-pull and Cost-push Inflation

Demand-pull and Cost-push Inflation

As the SAS shifts left, at the intersection of new SAS curve and AD curve unemployment rate is high and level of real GDP is lower than potential GDP. A GDP recessionary gap emerges The Bank of England might stimulate demand. AD curve shifts gradually. The price level rises again and real GDP increases.

Aggregate Demand Response The initial increase in costs creates a one-time rise in the price level, not inflation. To create inflation, aggregate demand must increase.

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Demand-pull and Cost-push Inflation

A Cost-push Inflation Process Figure 30.6 illustrates a cost-push inflation spiral. If the oil producers raise the price of oil, and the Bank of England responds with an increase in aggregate demand, a process of cost-push inflation continues.
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The Quantity Theory of Money

The Quantity Theory of Money The quantity theory of money is the proposition that, in q y y y p p , the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The quantity theory of money is based on the velocity of circulation and the equation of exchange.

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The Quantity Theory of Money

The velocity of circulation is the average number of times in a year a dollar is used to purchase final goods and services in GDP. Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M:

The Quantity Theory of Money

In an economy, however, many other transactions are made beside transactions of final goods and services. For example, transaction on intermediate goods, labour and on many non-real things, e,g., bonds and stocks, etc. If we include all the transactions made in an economy over a period of a year, then the value of V will be much higher. The velocity equation would be then

V = PY/M or MV = PY V in this equation means the number of times money supply (M) needs to change hands in a year in order to support transactions of final goods and services only. V here refers to income velocity
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V = PT/M or MV = PT Where T refers to all kinds of transactions made in an economy. V here refers to transaction velocity.
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The Quantity Theory of Money

The equation of exchange states that:

The Quantity Theory of Money

We can also express the equation of exchange in growth rates: Money growth rate + Velocity growth rate = Inflation rate + Real GDP growth rate Solving for the inflation rate: Inflation rate = Money growth rate + Velocity growth rate Real GDP growth rate

MV = PY
The quantity theory assumes that velocity and potential GDP are not affected by the quantity of money So in the money. equation:

P = (V/Y)M
(V/Y) is constant and a change in M brings a proportionate change in P.

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The Quantity Theory of Money

In the long run, the rate of velocity change is not influenced by the growth rate of money and is approximately zero So: Inflation rate = Money growth rate Real GDP growth rate In the long run, fluctuations in the money growth rate minus the real GDP growth rate bring equal fluctuations in the inflation rate.

Inflation and Unemployment: The Phillips Curve

A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for 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 shows the trade-off between the inflation rate and unemployment rate holding constant 1 The expected inflation rate 2 The natural unemployment rate Keyness advice was to raise AD to reduce unemployment during recession. However, when the economy is near full capacity raising AD might create a problem inflation inflation. If we try to reduce unemployment by raising aggregate demand, inflation will go up; if we try to keep inflation low by reducing demand, then unemployment will go up.

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Slide 26

If we want less of one evil, we must have more of the other evil. Thats the trade-off. Empirically, this trade-off was first demonstrated by Prof. A.W Phillips.
0 un

Phillips Curve

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Does it mean that the govt can achieve a low level of unemployment - even below the natural rate - simply by accepting a higher rate of inflation? The existence of the Phillips curve seems to suggest, yes.

But further analysis showed that there is a problem - if govt tried to hold unemployment below the natural rate rate, inflation may accelerate i.e. we may have to accept ever increasing rate of inflation.

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Suppose, the economy is initially at un, with zero inflation.

1
0 u1 un u

Govt decides to reduce unemployment by accepting some inflation.

PC0

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Central bank increases money supply, price level P goes up. If workers were not expecting this inflation, then they dont ask for higher W. Real wage W/P falls and unemployment goes down.

Suppose we now move to u1, with inflation 1. If the economy stayed there then there is no problem - govts there, govt s objective I achieved.

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But the economy will not stay there for long, because workers will eventually adjust their wage demand. Initially, they were used to zero inflation (when the economy was at un). So, they expected future prices to be the same as current prices: Pe = P.

On that expectation, they were happy with a W that met their target real wage W/Pe. But now that there is positive inflation, they will soon discover that P > Pe, and real wage is falling.

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Suppose 1 = 5%. P is rising by 5 per cent every year. So, with given W, real wage will be falling by 5 per cent every year. Surely, workers will not tolerate this for long.

Soon they will demand 5% rise in W every year. Once that happens, real wage will go back to the original level and unemployment will go back to the original level Un.

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This return to the original level of unemployment can be represented by a shift in the Phillips curve. The original Phillips curve PC0 - the one that goes through Un - was based on the expectation of zero inflation.

As long as workers are expecting zero inflation, govt can move to any point on PC0, by creating inflation. Thus with inflation rate 1, govt can achieve unemployment rate u1.

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But as soon as workers begin to expect 1 to continue in the future, they will revise their wage demand accordingly, and unemployment will go back to un. Now we have a new Phillips curve PC1, which is based on expected inflation 1.

1
0 u1 un PC1 PC0 u

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PC1 will be to the right of PC0. With this new curve, the original unemployment rate un will be achieved at the inflation rate 1.

Thus, govt. will be defeated in its objective of reducing p y , y unemployment. In fact, the only result will be some inflation, where there was none before. If govt is desperate, it can still try to reduce unemployment, by raising inflation even higher.

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Thus, it may choose to have 2, which on the basis of PC1, will give unemployment rate U1. That is, unemployment will come down from Un to the lower level u1, where govt wanted it to be in first place.

Why will unemployment come down? The same answer as before: prices are higher than what the workers expect.

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They are now expecting inflation 1 and their W have been adjusted accordingly. If actual inflation is 2 (> 1), then their real wage will fall, so firms will hire more labour and unemployment will fall.

But the problem is, if inflation persists at the rate 2, then workers will soon begin to expect it. They will then raise W accordingly, real wage will go back to the original level, and unemployment will go back to un. Phillips curve will shift again.

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Unemployment-InflationTrade-Off: Policy Implications

2

Phillips curve analysis leads to a number of important policy conclusions. (1) Unemployment can be reduced below Un through higher inflation, but only temporarily - only so long as workers dont expect the new rate of inflation.
PC2 PC1 PC0

1
0 u1 un u

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That is, govt will have to surprise the workers by creating higher inflation. But if the new rate of inflation persists, then surprise will eventually disappear.

Workers will then readjust their W and unemployment will come back to Un. So it is only in the short run that there is trade-off between inflation and unemployment; there is no tradeoff in the long run.

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Inflation and Unemployment: The Phillips Curve

The Long-run Phillips Curve PC0, PC1, etc. are short run Phillips curves. The long run Philli curve i vertical - whatever th i fl ti rate, Phillips is ti l h t the inflation t unemployment will revert to un in the long run. The long-run Phillips curve shows the relationship between i fl i and unemployment when the actual b inflation d l h h l inflation rate equals the expected inflation rate.

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Long run Phillips curve

(2) The only way demand management policy can keep unemployment permanently below un is by keeping on raising the inflation rate for ever - by allowing a permanently accelerating inflation.
u u1 un PC1 PC0 PC2

1
0

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Thus, if govt wants u1, then it will have to keep on raising the rate of inflation first from zero to 1,and then to 2, and so on. This is true for any other rate of unemployment less than un.

(3) If government wants to bring unemployment down permanently, the best way is to reduce the natural rate of unemployment itself. This will req ire s ppl side policies i e the policies ill require supply i.e., that work on the supply side of the labour market e.g., removing the labor market rigidities

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Labour market rigidities: Labour market regulation Minimum wage legislation Language Lang age barrier Discrimination

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