INFLATION

1. INFLATION A significant and persistent increase in the price level.

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3. Inflation and the Price Level • Inflation is a process in which the price level is rising and • money is losing value. • 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.

4. Deflation • A drop in the overall price level

5. Inflation and the Price Level

6. Inflation and the Price Level • The inflation rate is the percentage change in the price • level. • That is, where P1 is the current price level and P0 is last • year’s price level, the inflation rate is • [(P1 – P0)/P0] × 100 • Inflation can result from either an increase in aggregate • demand or a decrease in aggregate supply and be • 􀂃 Demand-pull inflation • 􀂃 Cost-push inflation

7. Causes of Inflation • Inflation is an increase in the overall price level. • Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time.

8. Stagflation • A condition of concurrent high unemployment (stagnation) and inflation

9. Cost-Push Inflation • An inflation triggered by increases in input prices

10. Causes of Inflation • Demand-pull inflation is inflation initiated by an increase in aggregate demand. • Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

11. Demand-Pull Inflation • An inflation caused by high levels of demand

12. Aggregate Demand • The total quantity of commodities that are demanded at various prices • Total spending in economy at alternative price levels.

13. Aggregate Supply • Total output of the economy at alternative price levels.

14. Changes in aggregate demand and supply cause the • equilibrium price level and real GDP to change • resulting in business cycles

15. Aggregate Demand and Aggregate Supply Curves ( Short-Run & Long-Run)

16. Aggregate Demand, Aggregate Supply,and Business Cycles

17. Demand Pull Inflation-Cost PushInflation• Demand-pull inflation: inflation causedby increasing demand for output• Cost-push inflation: inflation caused byrising cost of production• Examples:• Home prices• Oil prices

18. Aggregate Demandand Business Cycles

19. Aggregate Supplyand Business Cycles

20. Factors that affect AD • AD = C+I+G+NX • CONSUMPTION • Income, wealth, expenditure,demographics,taxes • INVENSTEMENT • Interest rates, Technology, Cost of capital goods, Capacity of utilization • GOVERNMENT SPENDING • NET EXPORTS • Domestic and foreign income, Domestic and foreign prices, Exchange rates, Government policy

21. Why the Aggregate DemandCurve Slopes Downward • • The reasons for its downward slope are • price-level effects: • – Wealth Effect (Real Wealth/Real Balances) • – Interest Rate Effect • – International Trade Effect (Substitution)

22. Aggregate demand curve

23. Shifting theAggregateDemand Curve

24. Effects of aChange inAggregateDemand

25. Demand-pull inflation: rapid increases in AD outpace the growth of AS, causing price level increases (inflation).

26. Aggregate Supply Aggregate Supply (AS) is the total of all the firm (market) supply curves. It shows the quantity of real GDP produced at different price levels. Short-run AS slopes upward because an increase in the price level (while production costs and capital are held constant on the short-run), means higher profit margins—firms will want to produce more.

27. AggregateSupply

28. Shape of Short-run AS (SRAS) • • In the short-run, the capital stock (the • number of factories and machines, etc.) are • held constant. • • Increasing the number of workers increases • output, but at a diminishing rate. • • Diminishing returns manifest as an ever steeper • SRAS curve.

29. The Shape of theShort-Run Aggregate Supply Curve

30. The Shape of Long-run AS (LRAS) • • Resource costs are NOT fixed. • – As prices rises, workers will want higher wages and • will eventually get them. • • The amount of capital is not fixed—firms can • build new plants and buy new equipment over the • long-run. • • In the long-run, AS is set by the production • possibilities curve—the capacity of the economy, • and is not affected by prices, hence is vertical.

31. The Shape of theLong-RunAggregateSupply Curve

32. Shifting the Long-RunAggregate Supply Curve

33. Changes inAggregateSupply

34. AggregateDemand andSupplyEquilibrium

35. Demand-Pull Inflation • Demand-pull inflation is an inflation that results from an • initial increase in aggregate demand. • Demand-pull inflation may begin with any factor that • increases aggregate demand. • Two factors controlled by the government are increases in • the quantity of money and increases in government • purchases. • A third possibility is an increase in exports.

36. Demand-Pull Inflation Initial Effect of an Increase in Aggregate Demand Figure 28.2(a) illustrates the start of a demand-pull inflation Starting from full employment, an increase in aggregate demand shifts the AD curve rightward.

37. Demand-Pull Inflation Real GDP increases, the price level rises, and an inflationary gap arises. The rising price level is the first step in the demand pull inflation.

38. Demand-Pull Inflation Money Wage Rate Response Figure 28.2(b) illustrates the money wage response. The higher level of output means that real GDP exceeds potential GDP— an inflationary gap.

39. Demand-Pull Inflation The money wages rises and the SAS curve shifts leftward. Real GDP decreases back to potential GDP but the price level rises further.

40. Demand-Pull Inflation A Demand-Pull Inflation Process Figure 28.3 illustrates a demand-pull inflation spiral. Aggregate demand keeps increases and the process just described repeats indefinitely.

41. Demand-Pull Inflation Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it. Demand-pull inflation occurred in the United States during the late 1960s and early 1970s.

42. 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 • 􀂃 An increase in the money wage rate • 􀂃 An increase in the money price of raw materials, such as • oil.

43. Effects of Inflation • Unanticipated Inflation in the Labor Market • Unanticipated inflation has two main consequences in the • labor market: • 􀂃 Redistributes of income • 􀂃 Departure from full employment

44. Effects of Inflation • Unanticipated Inflation in the Labor Market • Unanticipated inflation has two main consequences in the • labor market: • 􀂃 Redistributes of income • 􀂃 Departure from full employment

45. Effects of Inflation • Higher than anticipated inflation lowers the real wage rate • and employers gain at the expense of workers. • Lower than anticipated inflation raises the real wage rate • and workers gain at the expense of employers. • Higher than anticipated inflation lowers the real wage rate, • increases the quantity of labor demanded, makes jobs • easier to find, and lowers the unemployment rate. • Lower than anticipated inflation raises the real wage rate, • decreases the quantity of labor demanded, and increases • the unemployment rate.

46. Effects of Inflation • Unanticipated Inflation in the Market for Financial • Capital • 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. • If the inflation rate is unexpectedly high, borrowers gain • but lenders lose. • If the inflation rate is unexpectedly low, lenders gain but • borrowers lose.

47. Effects of Inflation • When the inflation rate is higher than anticipated, the real • interest rate is lower than anticipated, and borrowers want • to have borrowed more and lenders want to have loaned • less. • When the inflation rate is lower than anticipated, the real • interest rate is higher than anticipated, and borrowers • want to have borrowed less and lenders want to have • loaned more.

48. Effects of Inflation • Forecasting Inflation • To minimize the costs of incorrectly anticipating inflation, • people form rational expectations about the inflation rate. • A rational expectation is one based on all relevant • information and is the most accurate forecast possible, • although that does not mean it is always right; to the • contrary, it will often be wrong.

49. Effects of Inflation Anticipated Inflation Figure 28.7 illustrates an anticipated inflation. Aggregate demand increases, but the increase is anticipated, so its effect on the price level is anticipated.

50. Effects of Inflation • The money wage rate • rises in line with the • anticipated rise in the price • level. • The AD curve shifts • rightward and the SAS • curve shifts leftward so • that the price level rises as • anticipated and real GDP • remains at potential GDP.