CHAPTER 16 Inflation

1. ECONOMICS 5e Michael Parkin CHAPTER 16Inflation Chapter 33 in Economics

2. Learning Objectives • Distinguish between inflation and a one-time rise in the price level • Explain the different ways in which inflation can be generated • Describe how people try to forecast inflation

3. 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

4. Learning Objectives • Distinguish between inflation and a one-time rise in the price level • Explain the different ways in which inflation can be generated • Describe how people try to forecast inflation

5. 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.

6. Inflation and the Price Level • A one-time jump in the price level is not inflation. • Inflation is an ongoing process.

7. Inflation, ongoing process of rising price level A one-time rise in the price level Inflation Versus a One-TimeRise in the Price Level 160 150 140 Price level (1992 = 100) 130 120 110 100 90 1992 1993 1994 1995 1996 1997

8. 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.

9. – 120 126  Inflation  100 Rate 120 Inflation and the Price Level For example, if this year’s price level is 126 and last years was 120, then inflation is:  5 percent per year.

10. Learning Objectives • Distinguish between inflation and a one-time rise in the price level • Explain the different ways in which inflation can be generated • Describe how people try to forecast inflation

11. Inflation and the Price Level There are two sources of pressure on the price level and inflation: 1) Demand pull 2) Cost push

12. 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

13. 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.

14. 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.

15. SAS1 AD1 0 A Demand-Pull Rise in the Price Level Increase in AD raises price level and increases real GDP... LAS 130 Price level (GDP deflator, 1992 = 100) (cont.) (cont.) SAS0 121 …wages rise, and SAS shifts leftward. Price level rises further, and real GDP declines 113 110 100 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

16. 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.

17. SAS2 SAS1 AD2 AD1 0 A Demand-Pull Inflation Spiral LAS 133 Repeated increases in ADcreate a price-wage spiral Price level (GDP deflator, 1992 = 100) 125 SAS0 121 113 110 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

18. 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.

19. 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.

20. 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.

21. 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.

22. SAS1 0 A Cost-Push Rise in the Price Level Resource price rise shifts SAS leftward and causes stagflation LAS 130 Price level (GDP deflator, 1992 = 100) SAS0 120 117 110 100 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

23. 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.

24. SAS1 AD1 0 Aggregate DemandResponse to Cost Push LAS 130 Factor price rise shifts SAS leftward and causes inflation. Price level (GDP deflator, 1992 = 100) 121 SAS0 117 The Fed increases AD to restore full- employment and the price level rises again. 110 100 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

25. 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.

26. SAS2 SAS1 AD2 AD1 0 A Cost-Push Inflation Spiral LAS 133 129 Oil producers and the Fed feed cost-price inflation spiral Price level (GDP deflator, 1992 = 100) SAS0 121 117 110 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

27. 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.

28. 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.

29. Learning Objectives • Distinguish between inflation and a one-time rise in the price level • Explain the different ways in which inflation can be generated • Describe how people try to forecast inflation

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. Effects of Inflation Redistribution of Income • Unanticipated inflation leads to interest rates not being set high enough to compensate lenders. • Borrowers gain, lenders lose.

37. 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.

38. 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.

39. 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

40. 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.

41. Effects of Inflation Anticipated Inflation • Money wages are assumed to be sticky while an economy is experiencing demand-pull and cost-push inflation. • Correctly anticipating increases in the price level, people will adjust their money wage rates to compensate.

42. SAS2 SAS1 AD2 AD1 0 Anticipated Inflation LAS 133 Anticipated increases in AD bring inflation but no change in real GDP Price level (GDP deflator, 1992 = 100) SAS0 121 110 AD0 6.0 6.5 7.0 7.5 8.0 8.5 Real GDP (trillions of 1992 dollars)

43. 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.

44. 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

45. 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.

46. 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.

47. Effects of Inflation Increases Uncertainty • High inflation rates result in uncertainty about the long-term inflation rate. • Investment falls. • Growth falls.

48. 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

49. 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

50. 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