Types of inflation (and deflation)

1. Types of inflation (and deflation) Ch. 10, p. 280-283 What causes demand-pull and cost-push inflation? How do these types of inflation affect aggregate demand and aggregate supply? How do you graph the types of inflation?

2. Understanding the main causes of inflation • Inflation can come from both the demand and the supply-side of an economy, and can arise from internal and external events • Some inflationary pressures come from: • the domestic economy, for example the decisions of utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets. • A rise in the rate of VAT would also be a cause of increased domestic inflation in the short term because it increases a firm’s production costs. • Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages. • Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices for items such as foodstuffs from Western Europe or technology supplies from the United States – which feeds through directly or indirectly into the consumer price index.

3. Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap When there is excess demand, producers are able to raise their prices and achieve bigger profit margins because demand is running ahead of supply Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic Demand-pull inflation D-P Inflation is an excess of AD over AS at the full employment level of output. It’s caused by an increase in AD, a rightward shift on the AD curve. The graph above also shows a demand-side shock (when AD increases quickly in the short-run)

4. Initial increase in price level due to increased AD does not necessarily mean inflation, but could set the stage for d-pi. Inflationary expectations cause AD to feed on itself, as firms’ and households’ spending plans increase in anticipation of higher future prices. AD increases from AD2 to AD3; price increases to P3. This is unsustainable in the long-run, since higher final prices cause laborers to suffer real wage loss; wages are bid up. Demand-pull inflation, v. 2.0 This results in higher labor costs for firms and decrease in AS from SRAS1 to SRAS2. The economy has moved towards LR equilibrium (Y1) but at a higher price level, P4. The original shift in AD sets off a round of d-pi where AD increases beyond LR potential output.

5. If AD continues to rise (due to continued expectations of high inflation), then the economy can expect a process where: 1. prices increase 2. labor adjusts by bidding up wages 3. Firms scale back on production due to lower margins between input prices (i.e., labor costs) and final output prices D-PI “Spiral” Households anticipate higher inflation at A; AD increases to AD1; leads to another dp-i round (see last slide) and creates a spiral effect…

6. Main causes of Demand-pull inflation • A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country’s exports.  • If consumers buy fewer imports, while exports grow, AD in will rise • Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government spending.  • If direct taxes are reduced, consumers have more disposable income causing demand to rise. • Higher government spending and increased borrowing creates extra demand in the circular flow • Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand –like raising demand for loans or in leading to house price inflation. • Monetarist economists believe that inflation is caused by “too much money chasing too few goods” and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly. • Fast growth in other countries – providing a boost to exports overseas. • Export sales provide an extra flow of income and spending into the circular flow – so what is happening to the economic cycles of other countries definitely affects the home country

7. The Quantity Theory of Money • “the cornerstone of monetarism” • QTM states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. • If the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). • consumer therefore pays twice as much for the same amount of g/s • Another way to understand this: money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). • Increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.

8. In its simplest form, the theory is expressed as:MV = PT M = Money Supply V = Velocity of Circulation (the number of times money changes hands)P = Average Price LevelT = Volume of Transactions of Goods and Services Principle of "equation of exchange":Amount of Money x Velocity of Circulation (due to price levels) = Total Spending 1. Logic to equation of exchange: assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term. 2. Assumes that the quantity of money, which is determined by outside forces, is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services. 3. Number of transactions (T) is determined by factors of production, knowledge and organization. The theory assumes an economy in equilibrium and at full employment. Essentially, the theory's assumptions imply that the value of money is determined by the amount of money available in an economy. An increase in money supply results in a decrease in the value of money because an increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost more to buy the same quantity of goods or services. Assumptions: QTM

9. Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise: Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of: a rise in commodity prices such as oil, copper and agricultural products used in food processing. Rising labor costs caused by wage increases (when unemployment is low), greater than improvements in productivity. Wages might increase when people expect higher inflation: ask for more pay to protect real incomes unions may use their bargaining power to bid for and achieve increasing wages Cost-push inflation C-P Inflation is caused by a decrease in AS due to increases in costs of production (among others), a leftward shift on the AS curve=a supply-side shock (when AS decreases quickly in the short-run). This combination of a fall in output along with inflation is called stagflation.

10. As with demand shocks, the supply shock sets the stage for cost-push inflation. When laborers realize real wages have fallen due to higher price level, individual wage bargaining and unions will drive up wages to regain lost purchasing power. Higher cost of labor will shift AS even further left from SRAS1 to SRAS3. Price level rises from P2 to P3. The increase in wages (perhaps also with expansionary policies coupled with increased unemployment) increases consumption and AD from AD1 to AD2. C-PI v. 2.0

11. If final prices continue to rise due to increased consumption and fiscal stimuli, real wages have also fallen due to inflation. Another period of bidding up wages starts, creating successive shifts in SRAS and AD—the cost-push (wage-price) spiral. Increased price level Increased wages Increased costs to firms Increased price level… C-PI “Spiral”

12. Causes of cost-push inflation • Expectations of inflation are important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. • One of the dangers of a pick-up in inflation is “the wage-price effect” i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. • Higher indirect taxes –Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers. • for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. • A fall in the exchange rate –leads to an increase in the prices of imported products such as essential raw materials, components and finished products • Monopoly employers/profit-push inflation – where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs

13. Main consequences of inflation • Many governments have a target for a low but positive rate of inflation. They believe that persistently high inflation can have damaging economic and social consequences. • Income redistribution: One risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. • i.e., prices for food and domestic utilities rises at a rapid rate • Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes • Negative real interest rates: If interest rates on savings accounts are lower than inflation, people who rely on interest from their savings will be poorer. • Cost of borrowing: High inflation may lead to higher interest rates for businesses and people needing loans and mortgages; this as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt

14. Main consequences of inflation • Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. • Can lead to a rise in labor costs and lower profits for firms • Business competitiveness:If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. • This may create reduced export orders, lower profits and fewer jobs, lower trade balance. • Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. • This could lead to a lower level of capital investment spending

15. Final thought: a “third” view of money-driven inflation • Simplified version: monetarist view says that any increase in money not matched in real potential output (LRAS) as solely inflationary in the long run. • Ad the increase in AD has pushed equilibrium output beyond LRAS, the increase in real GDP will not last, since wages will rise to match labor demand, increasing costs for firms, pushing SRAS curve left. • Steering the economy primarily by regulating the money supply advocates minimum gov’t intervention in favor of a few simple guidelines, such as a central bank setting rates of monetary growth or inflation ceilings: • Monetary policy should be tightened when nominal interest rates are lower than nominal GDP growth (and vice versa).